Arnold Kling  

The Baumol Puzzle

Baiting Bryan... One-Sentence Macro Policy ...

When you buy a car, should the price include a licensing fee to the ancestor who invented the wheel?

That question is implicit in William Baumol's new book. I think that the answer is obviously "no," but it is less obvious to Baumol. The puzzle is worth thinking through, and I think that it helps to illustrate the differences between what Nick Schulz and I call Economics 1.0 and Economics 2.0.

In Economics 1.0, if you have competitive markets and approximately constant returns to scale, then payments to the suppliers of factors of production tend to be "right" in two senses. First, they provide the correct incentives to supply hours of work, effort, capital, and so on. Second, factor payments tend to reflect the relative contribution of the various factors.

If you think of innovation as a factor of production in this sense, then Baumol argues that innovators are under-compensated. Most of the benefit of innovation accrues to people other than innovators--ultimately, it accrues to consumers. Baumol sees this as inefficient in theory but good in practice. He thinks that we would have a wildly unequal distribution of income if innovators were paid for the full value of their innovations. His resolution of the puzzle is that society has contrived institutions that pay innovators less than the value of their innovations in order to reduce poverty.

I lean toward a different resolution of the puzzle. I would emphasize that:

1. With innovation, the relationship between effort and value is unknown ex ante. You do not know whether that idea you are working on is going to turn out to be the Lisa (Apple's first graphical-interface computer, which bombed) or the Mac. You do not know whether the problem you are trying to solve is going to require years of effort or yield to a moment of inspiration.

2. Useful innovations tend to be combinations of innovations, multiplied together. (Matt Ridley's catch-phrase is "ideas have sex.") The car requires the wheel, gearing, and the internal combustion engine (among other things). There is no way to compute the value of those innovations separately.

Combining (1) and (2), you do not know how valuable a current innovation will be in the future. Back in the stone age, who could know that the wheel would be useful in 2010 but that the hand axe would not?

(I should note in passing that it is physically impossible to pay a license fee to the inventor of the wheel today. The inventor is dead. Moreover, even if while the inventor was alive all of the wealth produced by the wheel could have been foreseen, there was not sufficient wealth available at the time to give the inventor the present value of his or her innovation.)

I think that the main reason that the wheel produced spillovers that far exceeded that which was needed to induce the effort required to invent the wheel is that there were unforeseen combinations of the wheel with other innovations. My guess is that this is true of much innovation. A transistor, by itself, is an interesting curiosity. But modified in many ways and combined with other innovations, it facilitates a revolution.

I believe that the "spillover effect," in which the benefit of innovation far exceeds the compensation paid to innovators, reflects this multiplicative combinatorial character of innovation. For Baumol, innovation seems to exist as a factor of production in an Economics 1.0 world, and it just happens that innovation is not as well compensated as other factors. He thinks we would get more innovation if it were properly compensated, but we do the right thing by redistributing the benefits to reduce poverty.

I think that the relationship between effort and value in innovation is much less precise. Innovation has combinatorial characteristics, making it difficult to value a single innovation. And innovation has long-term benefits which cannot be forecast and for which it is not feasible to pay compensation.

I do not think we can put the square peg of innovation into the round hole of neoclassical production functions. Baumol's puzzle is worth thinking about, but I do not think that Economics 1.0 is the right way to do it.

COMMENTS (5 to date)
Rebecca Burlingame writes:

People will often remain in the mindset of Economics 1.0 if they or their partners have remained employed at optimum levels. For instance, say your husband or wife invents a process that is adopted by their employer, but is not compensated for this. As long as one exists in this framework it does not seem fair.

Only when the entire spectrum of economic links is considered does it become apparent that direct compensation for innovation can upset economic balances. What would be an easy way to help the average person become aware of total economic linkages that need balance for economic mobility? In other words how does a person think outside the box on this.

Plamus writes:
With innovation, the relationship between effort and value is unknown ex ante.

Can value (or effort - a point Prof. Kling makes in the very next sentence) ever be known ex ante? What is value without the consumer it is valuable to? What use is attributing the value to the inventor, but not the investor who risked capital, or the consumer who "extracted" it by using the invention? If the idea is to optimize a posteriori in order to get a world in which everyone is better off, without accounting for the fact that things can, and do, change, you need a crystal ball, or some pretty robust (and unrealistic) assumptions.

mobile writes:

That the wheel goes back at least as far as the dung beetle also makes it properly remit a licensing fee.

Gary Shiu writes:

By describing the benefits from uses that are beyond the expectations and thereby could not possibly be envisaged by the innovator as "spill over" effect leaves the impression that the "spill-over" effect somehow could be internalized.

This in turn creates the false impression that there is a trade-off involved between efficiency (where all benefits from innvoation, including spill-over effects accrue to the innovators) and equity/distributional benefits (where some benefits, the spill-over portion, accrue to the consumers).

One way out, as you have suggested, is to think about the benefits through usage of the innvoation that is absolutely beyond the imagination of the innovator as simply a by-product or an unintended consequences of the innovation, not benefits somehow FAILED to be obtained by the innovator in question.

Jeremy, Alabama writes:

I'm surprised that licensing fees in perpetuity have not been seized upon by lefties looking for a reason to tax people. After all, we are all (probably) descendants of the guy who invented the wheel, a vastly important invention that deserves compensation, and rich people have more wheels than poor people.

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