Economics 201

Case of the Day: Appropriability and Incentives for Innovation

Historical tales invite us to think of inventors as amiable tinkers, toiling away in their garages to produce amazing new inventions to the great benefit of humankind. The stories of these wizards often don't even mention financial gain: the heroic inventor is depicted as being motivated solely by the thrill of solving a difficult problem.

Such individuals undoubtedly existed and there surely are some today: perhaps this characterizes some contributors to open-source software. But most any innovator must think about the possibility of reaping gains from his or her work. For one reason, everyone must earn a living and devoting thousands of hours even to an enjoyable hobby may take time away from gainful employment. For another reason, a successful innovation may lead to millions of dollars of revenue for someone; most innovators probably (and justly) think that they deserve at least some of this reward.

But in contrast to the classic portrait of the individual tinker-inventor, most modern innovation is done within the labs, offices, and factories of business firms. The people working on innovations are largely being paid to do so, and the firm paying the bills certainly expects to reap revenue from their labors.

Although most people use "invention" and "innovation" interchangeably, economists often make a distinction. An invention is a new idea that may or may not be economically useful; an innovation is an application of a new idea or a new application of an existing idea that results either in a new kind of product (product innovation) or a new and better process for producing an existing product (process innovation). We are going to focus on innovation rather than invention in this case.

We often think of innovation in modern economies as coming about through research and development. This is more true of some industries than others, but in sectors such as chemicals, heavy industry, and electronic hardware nearly all innovation comes out of the R&D labs of large corporations. In these R&D-intensive industries, firms have to consider investment in R&D as they would any other investment: evaluating the expected net present value of the dollars spent on R&D and comparing it to the return on alternative investments in physical or financial capital.

One of the crucial characteristics of investment in R&D is great uncertainty about the likelihood of success. A firm never knows whether a research project will yield a positive result or how valuable that result will turn out to be in terms of new products or processes. In the face of such uncertainty, it is important that the firm's successful research projects yield a financial reward that is sufficient to offset the many R&D failures that it is likely to suffer. In order to reap that reward from successful innovation, the firm must be able to profit from its innovation.

The appropriability tradeoff

Knowledge, which is the basis for much innovation, has to a large degree the two properties of a public good. It is nonrival in that additional people can use knowledge without reducing the ability of others to use it. It may also be nonexcludable because once a useful idea is out in public, it is difficult if not impossible to prevent it from spreading.

If technological information is nonrival, the marginal cost of sharing knowledge once it has been discovered is near zero. Thus, economic efficiency insists that it should be shared with everyone at zero cost so that it can be used up to the point where the marginal social benefit equals the (zero) marginal social cost. But if technological knowledge is shared freely once it is discovered, then the discoverer of the knowledge will gain no advantage from her efforts. Just as with public goods, everyone has an incentive to free ride on the research and development of others, letting other firms do the costly innovation and simply imitating their methods when the knowledge inevitably leaks out. If others can easily free ride in this manner, then the innovator will not gain from R&D, and therefore no firm will want to spend money doing research. Innovation, technological progress, and innovation will be slow or perhaps non-existent. Economic efficiency in the distribution and use of knowledge is gained at the expense of efficiency in the creation of knowledge. This is the "knowledge dilemma," the essential economic tradeoff in technological change.

The term "appropriability" refers to the ability of an innovator (a firm or individual) to appropriate some of the social gains that result from his or her innovation. If the prospect of profit is a principal factor motivating innovative activity, then strong appropriability should lead to high levels of research, development, and innovation. Thus, a set of institutional arrangements that lead to high appropriability may encourage a high rate of innovation and economic growth.

In contrast to the public-goods example above, imagine an innovator who creates a totally new and highly desirable product under an appropriability regime that is so strong that she has an effective monopoly on producing the product forever. Moreover, suppose that she can charge every customer exactly according to his willingness to pay, acting as a perfect first-degree price discriminator. In this extreme case, there would be no consumer surplus and, as the sole producer of the good, the innovator would capture every penny of the social benefit from her innovation. Thus, in this hypothetical example of extreme appropriability, any R&D project would be pursued that had expected social benefits higher than the expected costs of research, development, and production. In other words, investment in innovation (or knowledge creation) would be at the economically efficient level. However, no one except the innovator would gain anything from it!

More commonly, innovators gain some monopoly on their innovation but cannot price discriminate perfectly. To maximize profit, they charge a high price for the use of the innovation or for the products it allows to be produced. If the knowledge contained in the innovation and the use of the innovation are essentially nonrival, then charging any positive price is inefficient (because the marginal social cost is zero) and the innovation will be underutilized by society.

Thus, appropriability is a double-edged sword. Low appropriability leads to efficient distribution of knowledge but inefficiently low creation of knowledge; high appropribility improves the incentives for knowledge creation but puts up inefficient barriers hindering distribution. This is the appropriability tradeoff. In designing legal and economic institutions relating to innovation, policymakers must strike a balance between inefficiency in creation and distribution: allowing enough appropriability to encourage R&D but not so much as to deny the rest of society the benefits of technological progress.

Appropriability mechanisms

Economists have identified several means through which firms can attempt to appropriate gains from innovation. These appropriability mechanisms vary in effectiveness across industries and innovations, and they depend on the legal institutions of the economy in which innovation occurs.


The best-known appropriability mechanism is the patent, which is one example (alongside copyrights and trademarks) of an intellectual property right. To qualify for a patent, an invention must be useful, novel, and non-obvious (to professionals in the field), and must cover an invention within the bounds of patentable subjects such as new products or new processes. (You can't, for example, patent a mathematical formula even if you are the first to discover it. However, the subject range of patents has controversially been expanded in recent decades to include software, business practices, genetic structures, and life forms.) A patent grants a legal monopoly on use of an invention for a limited period of time (currently 20 years from the time of patent application). A patent holder may sue for damages against anyone who infringes her patent by using her patented production method or by producing, importing, or selling her patented good or service in the United States during the period of protection. As a quid pro quo for patent protection, the details of the invention are made public by the patent office. Thus, although they are not allowed to use the patented idea, rivals can get access to information about the innovation.

For some kinds of innovations, patent protection is very effective. In the chemicals and pharmaceuticals industries, firms patent a particular molecule for which they find an economic use. No one else can produce and sell that molecule while it is under patent. Because it is relatively easy to identify and prove infringement, chemical and drug companies are well protected by their patents and can charge monopoly prices for their products until the patent expires.

Patent protection is much weaker in other industries and for many process innovations. It is often quite easy for rivals to "invent around" an innovator's patent by using the information released in the patent to develop a non-infringing alternative that works almost as well as (or sometimes even better than) the original patented innovation. Because patent law leaves the responsibility for detecting and prosecuting infringements up to the patent holder, it can be costly to enforce one's patent rights, which can dissipate some of the economic gains that the patent would otherwise afford.

One advantage of patents relative to other appropriability mechanisms is that they are marketable. A firm that develops an innovation but that is not well positioned to produce the product on a mass scale can license the patent to more efficient producers. This allows specialization among firms, with those good at innovating focusing on R&D and those good a production buying licenses to the innovations and making the product.


An alternative to the patent is simply to keep one's innovation secret. As with patents, secrecy is more effective for some innovations than for others. Famously, the Coca-Cola formula has been kept a trade secret for over a century. (The formula has changed numerous times over that period, most remarkably to remove the cocaine in the late 19th century but also to change from sugar to corn syrup after the Cuban revolution and on other occasions when the costs of inputs has shifted.) In general, process innovations are easier to keep secret because the processes themselves occur behind the closed doors of a firm's factories. By contrast, product innovations can often be "reverse engineered" by imitators, allowing them to create identical products if there is no patent protection.

Staying ahead

Although a firm's rivals may be able to work around patents and reverse-engineer secret innovations, doing this and getting a rival product onto the market is likely to take considerable time, perhaps a couple of years or more. During this time, the firm will enjoy an effective monopoly and may earn profits from its innovation. One strategy that has proven successful for some firms is to use that period to develop the next generation of its product. If new products can be created quickly enough, the firm may be able to stay "one generation ahead" of its rivals even if appropriability through patents and secrecy is limited. Intel used this strategy effectively for about 20 years to stay ahead of rival chip-makers.

Control of complementary assets

Even if a rival firm can get around barriers of patents and secrecy, it must actually produce the innovative good in order to compete against the innovator. If there are key inputs that are effectively controlled by the innovator, it may be difficult for the imitating rival to get access to the supply networks that are required to be an effective competitor.

Questions for analysis

1. The Bayh-Dole Act of 1980 allows the intellectual-property rights from innovations developed under research grants from the U.S. government (for example, through the National Science Foundation) to be retained by the universities and researchers who made the discoveries. What are the benefits and costs of this policy? Do you think it's a good idea?

2. Many patent-holders license the use of their patents to other firms. What are the advantages of licensing for the inventor, the licensee, and society in general.

3. Some economists have proposed that patents with very high social value should be purchased from the inventor by the government so that their ideas can be freely used by all. What advantages can you see in this policy? What might be some difficulties in implementing it?

4. Governments (and even other organizations) have sometimes offered prizes for particular technological innovations. A famous historical example was a prize offered by the English government for development of a device for measurement of longitude. More recently, prizes have been offered for private space flight and for solar cars. What are the advantages and disadvantages of prizes for motivating technological progress?

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