Perfect Competition is Bad for Growth

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

You have to be careful in confusing “free markets” with “perfect competition”. By “free markets”, I think we mean free entry for new firms and/or products into the market. We don’t want restrictions on innovators from bringing their ideas to the market. We typically *assume* that free entry exists in economic models, but one thing that holds back development may be the absence of this free entry (think red tape and bad institutions).

But we don’t want “perfect competition” even if we do want “free markets”. One of the counter-intuitive things that comes up in growth courses is that perfect competition is not conducive to rapid growth. The story here involves a few steps

  • Growth is ultimately driven by innovation
  • People will innovate if they have incentives to innovate
  • The incentive to innovate comes from economic profits
  • Profits only exist when the innovator or firm has some market power

Innovators and/or firms need to charge a price greater than marginal cost to earn profits, otherwise there will be no incentive to innovate, and ultimately no growth. If you allow competitors to copy innovations they will drive the price down to marginal cost, eliminating profits and incentives for innovation. We want free entry of new firms with market power, but not free entry of imitators who produce perfect competition.

But perfect competition does maximize the combined consumer and producer surplus from a given product. So there is a tension here. Perfect competition maximizes the output of *existing* products, but minimizes the output from *potential* products. Think of it this way, if we decided that we had all the types of goods and services that we could ever want, then we’d want to enforce perfect competition. We would nullify every patent, and let competition take over to maximize the output of those existing goods and services. Nullifying patents (or any other kind of intellectual property) would crush the incentives to innovate, and we’d never get any new products.

This means that it is not obvious what the right policy is for intellectual property rights and/or competition in general. It depends on your long-run perspective. You can trade off long-run growth for a higher level of current output by canceling intellectual property rights. Or you can trade off current output for a higher long-run growth rate by enforcing property rights strictly, and probably instituting even stronger ones.

There is no *right* answer here, because it depends on your time preferences. But extreme answers are probably unlikely to be optimal for anyone. Strict perfect competition – allowing imitators to ensure P=MC – isn’t good because it prevents us from getting new products. Super strong market power – limiting each good to being produced by a perpetual monopolist, say – would shrink the availability of every existing product, even if it makes the incentive to innovate huge.

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Patents, Bargaining, and Innovation

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

The economics of endogenous growth imply a non-linear relationship between intellectual property rights (IPR) and innovative activity. Very low patent protections (or other types of IPR) and no one will want to bother innovating because they will not be able to reap any benefits before someone comes along and copies their idea. Too much patent protection (or other IPR) and it will be too hard to replace existing companies, so no one will bother to innovate. This means that there is a hump-shaped relationship of patent protection and innovation, with some area of optimal patent protection that maximizes the amount of innovation that gets done – just enough to encourage new innovators, but not so much that we freeze existing companies in place.

Two recent papers have some clues about that patent/relationship curve, but not in the way I was originally expecting. Bhaven Sampat and Heidi Williams have a paper (h/t Joshua Gans) on cumulative or follow-on innovation, meaning patents that are filed that rely on existing patents. They looked specifically at patents for genes, which allows them to clearly identify subsequent patenting activity. Within the patent office. They use a nifty strategy involving the random assignment of patent officers to get variation between genes that are patented and genes that are not. Comparing those with patents to those without, they find no difference in future innovation.

This is not what Alberto Gallaso and Mark Schankerman find (h/t Free Exchange). They use invalidations of patents by US Court of Appeals as the source of variation in intellectual property rights in their study. For some fields, invalidating a patent meant a tripling of the number of citations in future patents for that invalidated patent. So removing the IPR was a boon to future innovation. But this only held in fields where products rely a host of patents, think biotechnology in general or IT. For fields that they classified as simple, there was no effect of invalidating a patent on future innovation – similar to the Sampat and Williams finding.

Perhaps what these papers are telling us is that we should be more worried about shifts in the patent/innovation relationship, rather than movement along that curve. The Sampat and Williams paper shows that cumulative innovation is the same, regardless of whether the gene is patented or not. This suggests that a patent is simply re-distributing the total gains of cumulative innovations towards the current patent holder and away from the new innovator. But, the gains are realized though the cumulative innovation – the market appears to be figuring out for itself how to ensure these innovations get made. But note that this works for a very specific sub-field of research in which the use of an innovation (a gene) is clear cut.

The Galasso and Schankerman paper shows us what happens when the cumulative innovation is more complex. When a patent is struck down in a field that relies on webs of patents, there is a burst of cumulative innovative activity. Why? The many parties involved in the web of patents will find it hard to negotiate and allocate out the rents from the cumulative innovation. Practically speaking, it may be too hard to get everyone in the same room together. The court ruling solves the bargaining problem exogenously. It eliminates the need for the meetings, the e-mails, the lawyer’s fees, etc.. etc..

What Galasso and Schankerman are measuring, then, is the effect on innovation of lowering bargaining costs. This shifts the entire patent/innovation relationship up, meaning more innovation at any level of formal patent protection. In the Sampat and Williams study, the bargaining problem was already straightforward, so the difference in having a patent or not doesn’t affect anything. The costs were already low.

Now I’m not sure that his means we can fundamentally change innovation rates by lowering bargaining costs. The bargaining costs seem to be driven by the nature of the field. If the innovation is complex and relies on lots of other patents, then you cannot legally just decree that it is less complex. But definitive legal rulings are probably a boon to innovation, regardless of which way they decide. From a social point of view, we want to maximize innovations, and the exact distribution of the rents to the various patent-holders is not really our concern (Quick, do you care or know how the Apple/Samsung trial turned out? As long as various versions of smartphones remain available, probably not). So based on this, our goal with the patent system should probably be focused on making it transparent, fast, and cheap to navigate, as opposed to worrying precisely about who gets protected for how long.