13.2How Governments Can Encourage Innovation

Most prior innovation periods, such as the Industrial Revolution, had one significant downside: negative impacts on the environment, such as pollution and habitat destruction. Perez notes that our current revolution—in information and communications technology (ICT)—has the potential for significant positive externalities related to the environment. ICT is shifting many areas of society (and therefore industry) to digital experiences and services that do not require fossil fuels or similar natural resources. Vehicle sharing, product rental-reuse networks, and new manufacturing methods offer the promise of far less consumable consumption. And even though the appearance of delivery trucks and shipping boxes gives the impression of environmental damage, most studies indicate that online shopping is better for the environment than individuals shopping in person. (This is partly attributed to greater efficiency in a few trucks driving to a neighborhood rather than everyone in the neighborhood driving to several stores.) Consumers and governments can spur on those environmental benefits by choosing or partnering with companies that focus on furthering their environmental impact, such as by using solar power to fuel their computer servers or by using electrically powered delivery trucks. Like other innovations, ICT has created some employment and economic opportunities while it has reduced others. Increased globalization and efficiencies have shuttered businesses and reduced wages in some areas. Perez’s research indicates that those types of employment shifts can be managed through proper regulation and investment (especially in human capital), particularly as firms in the relevant industries become mature and profitable. The prospects aren’t simple: ICT has created megafirms like Amazon and Apple, which despite pleasing their consumers can wield significant power over governments and employees. But on the environmental and societal front at least, ICT has offered a wealth of opportunities and externalities.

13.2 How Governments Can Encourage Innovation

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain the effects of intellectual property rights on social and private rates of return.
• Identify three U.S. Government policies and explain how they encourage innovation

A number of different government policies can increase the incentives to innovate, including: guaranteeing intellectual property rights, government assistance with the costs of research and development, and cooperative research ventures between universities and companies.

Intellectual Property Rights

One way to increase new technology is to guarantee the innovator an exclusive right to that new product or process. Intellectual property rights include patents, which give the inventor the exclusive legal right to make, use, or sell the invention for a limited time, and copyright laws, which give the author an exclusive legal right over works of literature, music, film/video, and pictures. For example, if a pharmaceutical firm has a patent on a new drug, then no other firm can manufacture or sell that drug for 20 years, unless the firm with the patent grants permission. Without a patent, the pharmaceutical firm would have to face competition for any successful products, and could earn no more than a normal rate of profit. With a patent, a firm is able to earn monopoly profits on its product for a period of time—which offers an incentive for research and development. In general, how long can “a period of time” be? The Clear It Up discusses patent and copyright protection timeframes for some works you might know. CLEAR IT UP How long is Mickey Mouse protected from being copied? All patents and copyrights are scheduled to end someday. In 2003, copyright protection for Mickey Mouse was scheduled to run out. Once the copyright had expired, anyone would be able to copy Mickey Mouse cartoons or draw and sell new ones. In 1998, however, Congress passed the Sonny Bono Copyright Term Extension Act. For copyrights owned by companies or other entities, it increased or extended the copyright from 75 years to 95 years after publication. For copyrights owned by individuals, it increased or extended the copyright coverage from 50 years to 70 years after death. Along with protecting Mickey for another 20 years, the copyright extension affected about 400,000 books, movies, and songs. Figure 13.4 illustrates how the total number of patent applications filed with the U.S. Patent and Trademark Office, as well as the total number of patents granted, surged in the mid-1990s with the invention of the internet, and is still going strong today.

FIGURE 13.4Patents Filed and Granted, 1990–2020The number of applications filed for patents increased substantially beginning in the 1990s, due in part to the invention of the internet. The internet led to many other inventions, but also made it much easier to copy, steal, or "pirate" intellectual property, which led to the 1998 Copyright Term Extension Act. (Source: http://www.uspto.gov/web/offices/ac/ido/oeip/taf/us_stat.htm) While patents provide an incentive to innovate by protecting the innovator, they are not perfect. For example:

• In countries that already have patents, economic studies show that inventors receive only one-third to one-half of the total economic value of their inventions.
• In a fast-moving high-technology industry like biotechnology or semiconductor design, patents may be almost irrelevant because technology is advancing so quickly.
• Not every new idea can be protected with a patent or a copyright—for example, a new way of organizing a factory or a new way of training employees.
• Patents may sometimes cover too much or be granted too easily. In the early 1970s, Xerox had received over 1,700 patents on various elements of the photocopy machine. Every time Xerox improved the photocopier, it received a patent on the improvement.
• The 20-year time period for a patent is somewhat arbitrary. Ideally, a patent should cover a long enough period of time for the inventor to earn a good return, but not so long that it allows the inventor to charge a monopoly price permanently.

Because patents are imperfect and do not apply well to all situations, alternative methods of improving the rate of return for inventors of new technology are desirable. The following sections describe some of these possible alternative policies.

Policy #1: Government Spending on Research and Development

If the private sector does not have sufficient incentive to carry out research and development, one possibility is for the government to fund such work directly. Government spending can provide direct financial support for research and development (R&D) conducted at colleges and universities, nonprofit research entities, and sometimes by private firms, as well as at government-run laboratories. While government spending on research and development produces technology that is broadly available for firms to use, it costs taxpayers money and can sometimes be directed more for political than for scientific or economic reasons. LINK IT UP Visit the NASA website (https://openstax.org/l/NASA) and the USDA website (https://openstax.org/l/USDA) to read about government research that would not take place were it left to firms, due to the externalities. The first column of Table 13.3 shows the sources of total U.S. spending on research and development. The second column shows the total dollars of R&D funding by each source. The third column shows that, relative to the total amount of funding, 22.7% comes from the federal government, about 69% of R&D is done by industry, and less than 4% is done by universities and colleges. (The percentages below do not add up to exactly 100% due to rounding.) Sources of R&D Funding Amount ($ billions) Percent of the Total Federal government $129.6 21.4% Industry $426.0 70.3% Universities and colleges $20.7 3.4% Nonprofits $25.0 4.1% Nonfederal government $4.8 0.8% Total $606.1 TABLE 13.3U.S. Research and Development Expenditures, 2018 (Source: https://ncses.nsf.gov/pubs/nsf21324) In the 1960s the federal government paid for about two-thirds of the nation’s R&D. Over time, the U.S. economy has come to rely much more heavily on industry-funded R&D. The federal government has tried to focus its direct R&D spending on areas where private firms are not as active. One difficulty with direct government support of R&D is that it inevitably involves political decisions about which projects are worthy. The scientific question of whether research is worthwhile can easily become entangled with considerations like the location of the congressional district in which the research funding is spent.

Policy #2: Tax Breaks for Research and Development

A complementary approach to supporting R&D that does not involve the government’s close scrutiny of specific projects is to give firms a reduction in taxes depending on how much research and development they do. The federal government refers to this policy as the research and experimentation (R&E) tax credit. According to the Treasury Department: “. . . the R&E Credit is also a cost-effective policy for stimulating additional private sector investment. Most recent studies find that each dollar of foregone tax revenue through the R&E Tax Credit causes firms to invest at least a dollar in R&D, with some studies finding a benefit to cost ratio of 2 or 2.96.” LINK IT UP Visit this website (https://openstax.org/l/REtaxcredit) for more information on how the R&E Tax Credit encourages investment.

Policy #3 Cooperative Research

State and federal governments support research in a variety of ways. For example, United for Medical Research, a coalition of groups that seek funding for the National Institutes of Health, (which is supported by federal grants), states: “NIH-supported research added $69 billion to our GDP and supported seven million jobs in 2011 alone.” The United States remains the leading sponsor of medical-related research, spending $117 billion in 2011. Other institutions, such as the National Academy of Sciences and the National Academy of Engineering, receive federal grants for innovative projects. The Agriculture and Food Research Initiative (AFRI) at the United States Department of Agriculture awards federal grants to projects that apply the best science to the most important agricultural problems, from food safety to childhood obesity. Cooperation between government-funded universities, academies, and the private sector can spur product innovation and create whole new industries.

13.3 Public Goods

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Identify a public good using nonexcludable and non-rival as criteria
• Explain the free rider problem
• Identify several sources of public goods

Even though new technology creates positive externalities so that perhaps one-half or two-thirds of the social benefit of new inventions spills over to others, the inventor still receives some private return. What about a situation where the positive externalities are so extensive that private firms could not expect to receive any of the social benefit? We call this kind of good a public good. Spending on national defense is a good example of a public good. Let’s begin by defining the characteristics of a public good and discussing why these characteristics make it difficult for private firms to supply public goods. Then we will see how government may step in to address the issue.

The Definition of a Public Good

Economists have a strict definition of a public good, and it does not necessarily include all goods financed through taxes. To understand the defining characteristics of a public good, first consider an ordinary private good, like a piece of pizza. We can buy and sell a piece of pizza fairly easily because it is a separate and identifiable item. However, public goods are not separate and identifiable in this way. Instead, public goods have two defining characteristics: they are nonexcludable and non-rival. The first characteristic, that a public good is nonexcludable, means that it is costly or impossible to exclude someone from using the good. If Larry buys a private good like a piece of pizza, then he can exclude others, like Lorna, from eating that pizza. However, if national defense is provided, then it includes everyone. Even if you strongly disagree with America’s defense policies or with the level of defense spending, the national defense still protects you. You cannot choose to be unprotected, and national defense cannot protect everyone else and exclude you. The second main characteristic of a public good, that it is non-rival, means that when one person uses the public good, another can also use it. With a private good like pizza, if Max is eating the pizza then Michelle cannot also eat it; that is, the two people are rivals in consumption. With a public good like national defense, Max’s consumption of national defense does not reduce the amount left for Michelle, so they are non-rival in this area. A number of government services are examples of public goods. For instance, it would not be easy to provide fire and police service so that some people in a neighborhood would be protected from the burning and burglary of their property, while others would not be protected at all. Protecting some necessarily means protecting others, too.