The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism

Published by EH.NET (July 2002)

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.