William J. Baumol, The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism. Princeton, NJ: Princeton University Press, 2002. xii + 318 pp. $35 (hardcover), ISBN: 0-691-09615-5.

Reviewed for EH.NET by Joel Mokyr, Departments of Economics and History, Northwestern University.

William Baumol, who has been one of our most influential, original, and eminent economists for over half a century, keeps himself busy in his retirement years. In this wonderful and learned book, which draws on much of his earlier research, he revisits one of the most perplexing issues of our time. Whence innovation? Theory suggests that most societies tend to underinvest in the generation of new useful knowledge because property rights in it cannot be established very well, and the bulk of the benefits (eighty percent, Baumol estimates) accrue to others. We would therefore expect the process of technological progress to be highly inefficient, marred by externalities, public good problems, incomplete contracts, monopoly power, opportunistic behavior, and on and on. At the same time, Baumol points out, economic historians have shown unambiguously that technological progress has been one of the most potent forces in modern history, and responsible for the unprecedented rise in living standards in capitalist economies in the past two centuries. How, then, has such a highly defective process managed to be so successful?

Baumol's view of innovation and technology is that the bulk of it is produced within the system by rational homines economici. In modern capitalist economies the production of new technology has been routinized, manufactured by an innovation assembly-line (his term) and more or less resembles other inputs. "At heart, novel technology is simply another (durable) input to the production process" he notes (p. 80). The surprising things is that the free market turns out after all to be remarkably good at producing these innovations -- perhaps not perfect relative to some absolutist efficiency standard, but more effectively than any other system and much better than many have held possible. Baumol, who freely acknowledges his debt to Schumpeter, insists that innovation has been as important as price as the primary variable in the competitive process.

Much of the book is dedicated to the proposition that technological change is the outcome of a rational process of R&D and the market for new knowledge, which is amenable to the rules of microeconomics with some minor modifications (many of which are worked out in this book). The competitive process produces far more cooperation and sharing in the market for new technology than one would suppose, and the welfare implications of the resulting sustained innovation have been historic. The analytics used are quite traditional, yet they are handled with expertise and elegance.

The book consists of three parts. The first part argues that in an oligopolistic capitalist free market system, innovation is inevitable and economic growth will ensue naturally. The second part adapts some of the tools of price theory to deal with innovation, and the third part takes a long-term macroeconomic view of growth in history. The central message is clear: free market capitalism may not be an optimal system for technological progress, but it does far a better job at generating it than any other economic regime, and it has in the past shown that it can deliver the goods. Most of the concerns about the underprovision of technological knowledge, Baumol shows, can be attenuated under the right system of markets and incentives, as long as misguided anti-trust bureaucrats stay out of the hair of creative capitalists, and as long as the incentives in the system do not distort the allocation of resources from creative innovation to parasitical rent-seekers as so often tends to happen. Baumol points out the many interesting ways in which oligopolistic markets manage to fare much better at generating and managing innovation than one would believe.

It is always a pleasure to see how much economists with expertise in other areas benefit from economic history when they respect and study it. Baumol relies on the work of economic historians to show the unique success of free market capitalism as the only system capable of generating sustained innovation and through it growth. He maintains that other systems were capable of invention, but that continuing innovation by making technological progress itself an industry that provides inputs to others is the particular contribution of the industrialized West, and it is what made for the modern world. In particular, Baumol is a great believer in the potential of oligopolistic competition to create a great deal of innovation. A kind of technological arms race or "Red Queen Effect" forces firms to keep innovating just to stay even with their rivals, in a kind of race to the top process. At the same time, however, market processes see to it that such firms share and license their new knowledge among their competitors, and the diffusion of new technology is faster than is often believed.

In a few instances Baumol might have learned that some of the phenomena he finds surprising or at least less familiar have in fact been discussed by economic historians in some detail. Thus he discusses in considerable detail the cooperative dimensions of R&D, pointing out that firms often stand to gain from colluding in sharing the results of their work -- but he seems unaware of Robert C. Allen classic 1983 paper "Collective Invention" (in the Journal of Economic Behavior and Organization 4: 1-24). Again, there are many detailed discussions of patent licensing and Baumol rightly criticizes the view that patents create monopolies, arguing instead that they create markets in new knowledge, in which innovators license their new techniques to those who can use them efficiently -- a point made for nineteenth century American inventors by Naomi Lamoreaux and Kenneth Sokoloff in their paper in the Proceedings of the National Academy of Sciences (1996). These are minor quibbles in an otherwise most learned and thoughtful book, yet they point to the benefits of a continuing and more intensive interaction between economic historians and to those economists who "consume" their work.

Moreover, the economic historian tends to worry a bit about what is meant by a "capitalist free market system." The dichotomy between "free market capitalist" systems and "all others," employed by Baumol, may be a bit too rough for most specialists to swallow whole. Large parts of Medieval Europe and China under the Ch'ing dynasty were market economies, with a great deal of internal trade, financial institutions, well-defined and enforceable contracts, effective property rights, and so on. Whether they deserve the term "capitalist" or not seems almost otiose and perhaps is a good reason not to overuse the term. What is clear is that not all commercialized market economies in which people were more or less free to pursue their economic interests ended up being equally technologically creative and innovative. And the generation and selection of new techniques in the "free" markets in capitalist economies have a large component of political decision-making in them, and thus the essence of "free-markets" is more of a continuum than a dichotomous variable.

In Baumol's view of the world, knowledge is a commodity, produced by the system with R&D when the payoff is right. What is "known" -- that is, what is within society's capability to actually manufacture -- seems to play little role in his models. At some point (e.g., p. 268) he seems to believe that the net yield of inventive activity must be subject to diminishing returns "a scenario straightforward enough to require no explanation." But one wonders: does new useful knowledge really behave much like a commodity? Can a search for the unknown be truly routinized? If it is routine, how is it novel? Clearly, Baumol is correct in thus describing a world of what I have called microinventions, the cumulative small improvements in existing techniques that are responsible for most of the productivity gains that technological progress provides us. This kind of research can be and is routinized and surely responds to market incentives. Without major breakthroughs or macroinventions that launch the economy into new "technological paradigms," however, such innovations will eventually run into diminishing returns and peter out. The modern age was made, in the end, by the opportunities created by macroinventions, in which entirely new domains of natural phenomena were explored and then harnessed to our technological needs. But were these discoveries themselves -- and not just their exploitation -- the result of free markets? Can one infer, for instance that the nineteenth century discoveries in the fields of organic chemistry, electricity, or bacteriology (to pick a few areas almost at will) were driven by free market capitalism? Yet what would the innovation process during the second Industrial Revolution (1865-1914) have looked like without them?

Baumol is too smart and too well-read not to be aware of these difficulties. His analysis is exactly the kind of stuff that inspires economic historians and helps them formulate the issues, and is likely to guide and inspire the work of economic historians working in the general areas of technology and growth. The exchange between applied microtheorists and industrial organization specialists and economic historians promises many more gains from trade in the near future.

Joel Mokyr is the Robert H. Strotz Professor of Arts and Sciences and Professor of Economics and History at Northwestern University. His The Gifts of Athena: Historical Origins of the Knowledge Economy will be published this fall by Princeton University Press.