Arnold Kling  

Focusing on Entrepreneurs

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William Baumol's latest book is The Microtheory of Innovative Entrepreneurship. It is hard to think of an economist as important as Baumol who does not have a Nobel Prize. He is old enough to put himself out to pasture, but instead, like Douglass North, he keeps doing pathbreaking work.

Having said that, I think that to the extent that Baumol's book overlaps with From Poverty to Prosperity, I think our book packs a bit more punch. This adds to my sense of being wronged by the editors at Princeton University Press for not taking on our book.

Some excerpts and further comments below the fold.

p. 27:


The major breakthroughs have tended to come from small, new enterprises, while the invaluable incremental contributions that multiply capacity and speed and increase reliability and user-friendliness have been the domain of larger firms.

He suggests that small firms do the super-creative work, and large firms procure these innovations, by licensing the invention or buying up the small firm. I was shocked to find that Amar Bhide was not in the index. Bhide's book The Origin and Evolution of New Businesses provides a rich description of the innovation ecosystem, and Baumol could benefit from incorporating Bhide's work.

p. 37:


it is the presence of competitive market forces that generally imposes discriminatory pricing as a normal state of affairs in the arena of innovative activity

Remember my maxim that Price Discrimination Explains Everything. With innovation, a lot of the cost is fixed cost of research and developement, and marginal costs of production and distribution are often low. You need to charge a price above marginal cost in order to recover fixed cost, and yet you often want to charge something close to marginal cost to your low-demand (or high-elasticity-of-demand) customers.

In order to price discriminate, the textbooks say you have to have some monopoly power. Baumol is suggesting that it is paradoxical that competitive pressure leads to price discrimination. The way I see it, he is thinking in terms of monopolistic competition, where firms can select prices along a downward-sloping demand curve but there is sufficient entry to drive profits to zero. The added wrinkle to textbook monopolistic competition is Baumol's claim that price discrimination is also possible in these markets.

Think of airlines. If you do not price discriminate by charging low prices to standby passengers and early bookers, you will forego profits. In a market where entry is going to drive profits to zero for efficient firms, your foregone profits means you will take losses and be driven out of business.

p. 54:


there are many entrepreneurial occupations that contribute little or nothing to an economy's output--or whose activities even reduce it, including, for example, rent-seeking lawyers who design new ways of pursuing remunerative litigation, the warlord organizers of private armies who invent nominal military strategies...

His point is that when institutions reward productive enterprise, you get growth, and when they reward unproductive redistribution, you don't. This is hardly an original point. It was made quite succinctly by North in his speech accepting the Nobel in 1993, where he said, "if the institutional framework rewards piracy then piratical organizations will come into existence; and if the institutional framework rewards productive activities then organizations - firms - will come into existence to engage in productive activities."

Baumol seems to have a general blind spot for institutional economics. North gets only one relatively tangential mention. No mention of Avner Greif or Joel Mokyr.

A lot of Baumol's focus is on the rewards, or lack thereof, of innovation. For large, incumbent oligopolists, Baumol argues that innovation is forced on firms, even though it is not profitable. He draws a parallel with the kinked demand curve story of textbooks. There, if you cut your price, your competitor will follow, and you gain nothing. But if you raise your price, your competitor may not follow, and you can lose a lot. So you try to maintain a stable competitive position.

Similarly, when it comes to innovation: if you innovate, so will your competitors, so your profit will be competed away. However, if you do not innovate, your competitors will, and you will be driven out of business. So you keep innovating in order to maintain a stable competitive position.

Another point Baumol emphasizes is that entrepreneurs earn little on average, while others in society reap huge rewards from innovation. Another way to put this is that if innovators were able to capture all of the rents from innovation, then the average person's standard of living would have nothing to show for innovation. In fact, it is closer to the opposite. The average standard of living has gained tremendously from innovation, but the average entrepreneur earns a below-normal economic profit. A few entrepreneurs do spectacularly well, but most are losers in an innovation lottery. Baumol suggests that people become entrepreneurs out of overoptimism and pursuit of psychic rewards.

The way I have always thought about the way innovation adds to wealth has been to think in terms of increasing returns. David Warsh's book Knowledge and the Wealth of Nations emphasizes that point. Instead, reading Baumol, I feel like I am back in the world of constant returns under competitive conditions, where one expects a close match between effort/ability and reward. In Warsh mode, I don't ask where all the positive spillovers from innovation come from--I just wave my hands and say "increasing returns." Baumol forces you to wonder how it is that benefits from innovation do not all accrue to the innovators.

Our book does not discuss these distributional issues. Baumol has much more to say about them--in the end, he does not think the institutional framework in this country provides too much or too little incentive for innovation. He also has more discussion than we do of the issue of dissemination of innovative ideas, with a focus on licensing.

Although Baumol pays some lip service to the incremental nature of innovation, the thrust of the book is to treat innovation as if it involved leaps of individual genius. I think one gets a different, and probably more helpful, picture by thinking about innovation in Matt Ridley's evolutionary terms and by remembering what Bhide calls (in another book) "the venturesome consumer."

Overall, I would say that compared with Ridley's book or our book, Baumol gives a professional economist a bit more to chew on, at least regarding issues of how the competitive process works to allocate rewards from innovation. On the other hand, I think that laymen will find Ridley's book gives a more sweeping historical analysis, while our book covers more ground and is easier to follow.



COMMENTS (2 to date)
blink writes:

Re: the p. 37 quote, I think we'd reach a better understanding if Baumol said "product differentiation" instead of "discriminatory pricing." In your airline example, late bookers really receive a different and more valuable product that costs more to produce -- the airline risks leaving seats empty or compensating another passenger bumped from the flight.

When investigating apparent price discrimination, our first question is, "Where's the market power?" Finding none, our next question ought to be, "How do the products differ?" Perhaps he has some clean examples of his own, but I'm not convinced that Baumol exhausted the differentiation angle.

GU writes:
"there are many entrepreneurial occupations that contribute little or nothing to an economy's output--or whose activities even reduce it, including, for example, rent-seeking lawyers who design new ways of pursuing remunerative litigation . . ."

I'm a lawyer, and I wholeheartedly agree with this point. But if you really believe this, you might want to stop advocating for the abolition of licensing for lawyers. Many seem to believe that if we could increase the supply of lawyers, prices for legal services would decrease severely, like DVD players or computer chips.

In reality, the legal market is already oversaturated. More lawyers means more of the bad type of "entrepreneurship" Baumol is referencing above. Based on my experience, the Econ 101 model of the world where licensing is always bad, is wrong. Law is more of an "idle hands" profession—if lawyers can't get respectable work, instead of quitting law they think of new ways they can fool idiots into suing the government/businesses for frivolous reasons. Increasing the number of lawyers leads to more "idleness" and more unnecessary litigation.

Remember, the supply of people who could be competent lawyers is very small; it is a natural oligopoly of sorts. Expecting the market price for legal services to follow the same trends as technological widgets is unrealistic.

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