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

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

by William Baumol

ISBN: 9780691116303

Publisher Princeton University Press

Published in Business & Investing/Popular Economics

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Sample Chapter

Chapter One



The Bourgeoisie [i.e., capitalism] cannot exist without constantly revolutionizing the instruments of production Conservation of the old modes of production in unaltered form was, on the contrary, the first condition of existence for all earlier industrial classes The bourgeoisie, during its rule of scarce one hundred years has created more massive and more colossal productive forces than have all preceding generations together.
   -Karl Marx and Friedrich Engels, 1847
As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology . . . -competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door.
   -Joseph A. Schumpeter, 1947, p. 84

Under capitalism, innovative activity-which in other types of economy is fortuitous and optional-becomes mandatory, a life-and-death matter for the firm. And the spread of new technology, which in other economies has proceeded at a stately pace, often requiring decades or even centuries, under capitalism is speeded up remarkably because, quite simply, time is money. That, in short, is the tale told in this book-an explanation of the incredible growth of the free-market economies. The capitalist economy can usefully be viewed as a machine whose primary product is economic growth. Indeed, its effectiveness in this role is unparalleled. The primary purpose of this book is to attempt an explanation of how this machine works. Note the underlying observation: that its extraordinary record of innovation and growth is hardly fortuitous. Nor is it the result of unrelated external developments analogous to the end of the "Little Ice Age" that occurred just after the inception of the Industrial Revolution and that probably contributed substantially to agricultural output. The point is that, once capitalism was in place and fully operational, a flow of innovation and the consequent rise in productivity and per capita gross domestic product were to be expected. Whatever the deficiencies of the free market, it is certainly very good at one thing: the manufacture of economic growth.

And, as is true of the other accomplishments of the market economy, none of this was the result of deliberate decisions or planning. The free market, once the institutional impediments to its development had been reduced sufficiently, just grew by itself and by itself became the machine that generates innovation and growth in dramatic profusion. For, as will be shown here, the market economy's makeup is such as automatically to ensure that result. This suggests that the analysis provided in this book, if it proves valid, promises to be of substantial value in practice, particularly to those nations that have not yet shared in the growth benefits proffered by the market, and whose relative poverty seems actually to be increasing.

How large a share of the economy is constituted by the growth machine? If we focus on the machine's central component alone-its research and development (R&D) activity-the numbers are not impressive. In 1998, total U.S. expenditure on R&D from all sources amounted to about $227 billion, or some 2.6 percent of gross domestic product (GDP). This share of GDP was growing, but only slowly: an average of about 1.4 percent per year over the forty-five years, 1953-98.1

This is, however, too narrow a view of the growth apparatus. The available estimates indicate that more than 60 percent of the labor force in the United States is engaged in activities in the "information sector" of the economy (though it is difficult to define and measure unambiguously)-far more than in manufacturing and agriculture, which, combined, constitute less than 20 percent of the total. This sector includes the processing, recording, analysis, and dissemination of information. It also encompasses the training of those who will carry out the nation's R&D in the future. Of course, much of the activity of the information sector has little connection with growth, but it is implausible that its growth-supporting work constitutes a negligible share of the total. The evident conclusion is that, whereas the core activity in the growth machine is hardly enormous in size, a very substantial part of the U.S. population that is economically active outside the household is at least peripherally engaged in running the machine.


It is the spectacular and historically unprecedented growth rates of the industrialized market economies-the growth rates of their productivity and their per capita incomes-that, above all, set them apart from all alternative economic systems. Average growth rates for about one and a half millennia before the Industrial Revolution are estimated to have been approximately zero, and, although there was undoubtedly some growth starting around the tenth century, it proceeded at a snail's pace by modern standards. Even the most well-off consumers in pre-Industrial Revolution society had virtually no goods at their disposal that had not been available in ancient Rome. In fact, many consumption choices available at least to more-affluent Roman citizens had long since disappeared by the time of the Industrial Revolution. In contrast, in the past 150 years, per capita incomes in a typical free-market economy have risen by amounts ranging from several hundred to several thousand percent!2 So, when public indignation contributed to the collapse in the late 1980s and early 1990s of many of the world's communist regimes, and when even the masters of China turned toward capitalist enterprise, what they wanted, surely, was to participate in the growth miracle that Karl Marx and Friedrich Engels were able to discern so early in the experience of capitalism.

This book seeks to explain the unprecedented and unparalleled growth performance of the capitalist economies and provides a theory of the imperfect but, nevertheless, creditable efficiency of the capitalist growth process. The analysis attributes this performance primarily to competitive pressures, not present in other types of economy, that force firms in the relevant sectors of the economy to unrelenting investment in innovation and that, contrary to widespread belief, provide incentives for the rapid dissemination and exchange of improved technology throughout the economy. Finally, the book moves toward the integration of growth theory into the central body of mainstream economic analysis. It is clear that innovation plays a far larger role in the activities of many key firms and industries than the current theoretical literature takes into account. My goal here is to indicate ways in which the analysis of business decisions can be reoriented to eliminate this significant gap. Let me indicate what I hope to achieve here in each of these areas.

Explaining the Growth Miracle of Free Enterprise

The virtual absence of any explicit attempt to explain the fabulous growth record of the free-enterprise economies in general, with their transformation of living standards and creation of technological innovations undreamed of in any previous era, is perhaps the most glaring omission of recent economic growth theory, despite all of its substantial contributions. I have been unable to find any systematic theoretical work seeking to account for this incredible record, or any investigation of why this economic system is so different in its productivity accomplishments from all other economic systems that have ever been tried.3

I will concentrate on a number of explanatory influences, including some necessary preconditions for the existence of a workable free-market economy, some likely consequences of the existence of such an economy, and some items that are both. Among the most important of these conditions are:

  • Oligopolistic competition among large, high-tech business firms, with innovation as a prime competitive weapon, ensuring continued innovative activities and, very plausibly, their growth. In this market form, in which a few giant firms dominate a particular market, innovation has replaced price as the name of the game in a number of important industries. The computer industry is only the most obvious example, whose new and improved models appear constantly, each manufacturer battling to stay ahead of its rivals.

  • Routinization of these innovative activities, making them a regular and even ordinary component of the activities of the firm, and thereby minimizing the uncertainty of the process. It is estimated that some 70 percent of U.S. research and development spending is now done by private industry, much of it incorporated into firms' day-to-day activities.

  • Productive entrepreneurship encouraged by incentives for entrepreneurs to devote themselves to productive innovation rather than to innovative rent-seeking (the nonproductive pursuit of economic profit such as occurs in inter-business lawsuits), or even to destructive occupations, such as criminal activities

  • The rule of law, including enforceability of contracts and immunity of property from arbitrary expropriation.

  • Technology selling and trading, in other words, firms' voluntary pursuit of opportunities for profitable dissemination of innovations and rental of the right to use them, via licensing, even to direct competitors.

All of these are features of a capitalist, or free-market, economy; in other types of economy they are either absent or exist in far weaker form. I will argue that these features are crucial for the explanation of the extraordinary growth accomplishments of the free market. Moreover, neither their consequences nor their origins are mere accidents, but contain elements that economic analysis can help to explain.

Imperfect but Substantial Economic Efficiency and Growth under Capitalism

My second central topic is the rough economic efficiency of the growth process of the free-market economies. Textbook accounts suggest that free-enterprise economies are characterized by a tendency toward static efficiency. That is, firms are driven by market forces to use the most economical of the available methods of production and to supply the product mix best suited to consumer demands. But, according to these accounts, these economies are also distinguished by extreme violation of the requirements of efficiency in the growth process. Most notably, the very substantial spillovers that derive from innovation-the fact that a considerable proportion of the benefits of innovation is enjoyed by persons who have not contributed to the innovation-are said to lead to a magnitude of innovative activity far below the optimum level.4 If inventors could retain more of the gains for themselves, the argument goes, there would surely be more inventions, and current inventors would surely put more effort into the process. Yet this conclusion seems to fly in the face of the observation that the main achievement of the capitalist economy is in fact its spectacular and unrivaled growth performance, and not its rather questionable static efficiency.

One need not be an economic historian to conclude that disparities in static efficiency do not constitute the really dramatic difference between the capitalist economies and the economic systems that preceded it, as well as those that were until recently designed to displace it. Undoubtedly, the rules of static efficiency were violated in both medieval China and the defunct Soviet Union where, for example, input prices must frequently not have been those that induced the most efficient use of labor and raw materials. But such efficient pricing is probably also widely missing today in the United States, Japan, and Germany. And even if these three countries came closer to satisfying that criterion, one may well doubt that the resulting contribution to living standards would be profound.

These observations underlie one of the main heterodox conclusions of this book: although the capitalist growth process certainly does not quite meet the requirements of perfect economic efficiency, there is reason to believe that it comes far closer than standard economic theory might lead us to conclude. Spillovers do, indeed, tend to impede the introduction of innovations whose social benefits (unlike their private returns) exceed their costs. Yet I will argue that, once the beneficial distributive consequences of the spillovers of innovation are taken into account, the result is likely to approximate something like optimality, in a sense to be defined. Finally, the profitability of the rental of proprietary technology enhances the rapidity with which the economy moves toward the current technological frontier, that is, toward adoption by most or all producers of the latest and most appropriate technology and product specifications. These forces together lead to a degree of efficiency in growth that, though far from perfect, is nevertheless impressive.

Incorporating Growth Analysis into Mainstream Microeconomic Theory

Innovation and growth surely originate from the activities of individuals and business firms-the entities studied in microeconomic analysis. Growth therefore cannot be fully understood without incorporating it into microeconomic theory. Yet the core of that body of analysis contains little on the subject. It will be argued in this book and, I trust, demonstrated that innovation can fortunately be integrated into the standard structure of micro-economic analysis more directly and more easily than might be expected. This is made possible by the competitive market pressures that force firms to integrate innovation into their routine decision processes and activities, thereby subjecting it to standardization and to the calculus of profit maximization. In addition, its place in the structure of microeconomic theory is facilitated by the recognition that, to a profit-seeking firm, investment in research and development is just another investment option, and that the products of this R&D are just intermediate inputs to the production of other outputs by the proprietor of the innovation and other business firms.

As a longtime practitioner of microeconomics, I certainly do not want to denigrate its very substantial accomplishments.


Excerpted from "The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism" by William Baumol. Copyright © 2004 by William Baumol. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.
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