To what extent do market failures result in a similar optimal allocation of resources to the innovation process Essay Example

To what extent do market failures result in a similar optimal allocation of resources to the innovation process Essay Innovation has a crucial impact on the standards of living in particular economy. It is generally agreed that research and innovation are the main sources of growth and job creation in market economies. i. e. output is increased through greater acquisition of knowledge. Subsequently, 2 things matter for economic growth: savings and the state of the productive knowledge (i. e. shows how productivity the extra capital will be used). The production function diagram below can illustrate this Where labour productivity per worker experiences diminishing marginal returns This diagram shows how economic growth can be realised by accumulation of capital and/or higher levels of knowledge. It should be noted that productivity growth is the difference between the growth of inputs and the growth of outputs and that technological progress is measured as residual-so that any problems with measuring inputs or outputs, will be transferred onto measuring technological progress. There are 2 movements on the diagram: a to b due to the accumulation of capital and b to c due to the growth of productivity or technical progress. The difficulty with this is that if knowledge had not changed, the movement from a to b will not have been experienced. The only reason capital has been accumulated is due to the increase in technical progress. Generally speaking technological progress generates new wealth in two ways: either through innovative process which help to increase the productivity of labour and capital and thus enable production levels to increase and/or to save available resources, or through innovative products which lead to the creation of new markets and industries and give a boost to investment and create jobs, Hence the principal source of growth is innovation. A general consensus states a positive incidence of technological progress on growth, competitiveness and employment. We will write a custom essay sample on To what extent do market failures result in a similar optimal allocation of resources to the innovation process specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on To what extent do market failures result in a similar optimal allocation of resources to the innovation process specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on To what extent do market failures result in a similar optimal allocation of resources to the innovation process specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Enormous amounts of money are spent on innovation and studies reveal that the economic return on innovation is very high in relative terms. Reviewing the diagram on returns to innovation below can see this. Graph2 The demand curve indicates the marginal valuations of this particular product and it is assumed that a single monopoly supplier produces the goods with constant marginal costs c and sets prices above marginal costs at P. The private rate of return is B as the firm exploits its product and receives a private rate of return extended over time against the cost of innovation. The social rate of return is larger as it is the sum of the private return and consumer surplus i. e. (A+D). Better measures can be seen empirically as Nadiri (1993) concluded that the private return on innovation was usually around 20 to 30% and the average social return close to 50%. This begs the question, why are such less resources devoted to innovation even though the rate of returns to society is so high? There are many reasons to this, which I shall discuss later, but crucially it depends on the view of markets and competition. There are 3 types of views: classical (emphasis on the rate of return equalises at the competition level), the dominant view of neoclassical state of equilibrium underpinning welfare economics and economic allocation) and the dynamic view of Austrians (looks at markets as creative and focuses on innovation as an economic process and entrepreneurs as key agents). In the early 1960s various specialist agreed perfect competition was incompatible with innovation as it required huge resources and exploitation of innovation suspected increasing returns. It was typically found that industries that regarded innovation as important were concentrated industries not perfectly competitive which were consistent with Pareto optimality, Hence the reason why neoclassical firms did not optimally allocate resources to organise and fund innovation. Numerous authors like Arrow (1960), Mansfield (1968) and Nordhaus (1969) pointed to market failure- that prevent the attainment of pareto equilibria by violating one or other of the conditions for perfect competition and explained that absence of the government in the free operation of the market would lead companies to under invest in basic innovation. Market failure may be explained in terms of four aspects: uncertainties (missing markets), appropriability, indivisibility and public goods. The innovation process both generates and is influenced by uncertainty and this aspect of market failure is particularly damaging to the possibility of a Pareto-efficient allocation of resources to invention and innovation. It is the inherent level of uncertainty, which most distinguishes an R+D project from a traditional industrial investment project. Innovation entails numerous scientific, technological and commercial uncertainties, which make it difficult for financial bankers to forecast results and monitor their investment project. Put briefly, missing or future markets for contingent claims in an uncertain world do not exist in any sense sufficiently for individuals to take risks in an optimal fashion. In addition to the uncertainties, providers of capital face another major difficulty: this derives from the intangible nature of innovation and the fact that investment cost is not recoverable. Consequently, the percentage of innovation projects, which are successful and generate a return on a large investment, is usually low. Thus financial backers insist on real guarantees to cover themselves if the investment fails. It is difficult to ascertain optimal levels of innovation in an uncertain world due to the existence of information asymmetries; Stiglitz (1991) makes it clear, that the resulting unequal distribution of knowledge creates problems of adverse selection and moral hazard, which deny the possibility of Pareto-optimality. Fundamentally, innovation and information asymmetries can be regarded as one, stating not only a trade-off between static and dynamic efficiency but also that innovation and pareto-optimality are incompatible. Another market failure is appropriation externalities. They have always been recognised as a major constraint on the incentives to innovate, as investors cannot appropriate to themselves the full amount of profits, which result from their funding of research and innovative activity. Furthermore, applied and/or industrial R+D is not altogether free of this imperfect appropriablilty of profits, which investors have. Despite advances in intellectual property rights in recent years, innovative processes and products developed by companies can easily be imitated by others and in some cases with relatively little effort and capital cost. For instance, studies in Europe put the total losses as a result of imitations alone of EU companies at nearly 50billion ECU in 1994. This led to lost earnings and huge numbers of job losses. However efficient the level of protection afforded by international law, there is no question of investors being able to appropriate the entire profits from their investment in innovation; not only for the reasons stated already but also because of the powerful external factors affecting innovation activities and the indirect spin-offs from them. As, had been stated earlier, the social rate of return may exceed private rates of return, private investors only receive a small return on their investment, and therefore it is necessary for governments to act to close the gap between private and social yields on technology investment. Next, the indivisible nature of the innovation process constitutes another major obstacle to optimum allocation of private capital. If R+D activity were perfectly divisible and it were possible to predict the social and private impact of each project, it would no doubt have been easier to separate funds required between public and private capital. However, phases of the innovation process are independent and the results are often unpredictable. Also indivisibilities inherent to the innovation process imply that there are increasing returns to the exploitation of technology and that it will be necessary for firms to retain some market power if they are to recover the costs to innovation. At best, an innovating industry can be monopolistically competitive, and from this different angle, Pareto efficiency and innovation are seen to be incompatible. The, last case regards science and technology as public goods i. e. non-rival, in the sense that the marginal cost of reproducing these is negligible and their owners exercise little control over the way in which they are used. In the free market economy it makes sense for the government to find the production and/ or dissemination of scientific knowledge. But this justification of the government role in funding basic research has been challenged by recent innovative approaches because the public good attributes of scientific and technological knowledge implies that market solution to the allocation of resources to innovation will not be efficient. Economists have identified other sources of market failure such as transaction costs, the national features of some corporate governance models, the reluctance of monopolies to fund innovative work, etc. The EU introduced a science and technology policy as to corrective for pervasive market failures and also due to the emergence of the single European market. The policy emphasised obvious areas of collaboration for R+D and innovation in order to be more competitive with USA and Japan and to compete with the low wages in South America. Currently, member states are spending 1. 9% of their resources on innovation compared with 2. 5% in Japan and 2. 7% in USA. Recently, the EU set the target at an overenthusiastic 3% The policy corrects market failures in uncertainties by appropriating price structures in the missing markets and thereby reducing distortions. Moreover, missing markets imply the need for agents to form expectations on the likely private values of their questions, expectations which policy can certainly influence. Given all these difficulties, which arise from the innovation process, it would seem to be wishful thinking to imagine that scientific and technological progress could be adequately funded in all the market economies without some form of government assistance. However one needs to recognise that government intervention can fail as well. Such examples are, imperfect information, the benefit between those who pay and those who benefit, bureaucratic capture and pressure group activity. It does not automatically follow that government policy will be welfare-improving. This is particularly so with respect to innovative activates, the formulation of which entails access to detailed microeconomic and social information