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Why the private sector under invests in innovation

Read about how private companies tend to invest less than they should in innovation. (Hint: it's because many of the benefits are external)

Key points

  • New technology often has positive externalities—in other words, there are often spillovers from the invention of new technology that benefit firms other than the innovator.
  • The social benefit of an invention, once these spillovers are taken into account, typically exceeds the private benefit to the inventor.
  • Competition creates pressure to innovate. But, if new inventions can be easily copied, the original inventor loses the incentive to invest further in research and development.

Why innovate?

Market competition can provide an incentive for discovering new technology—a firm can earn higher profits by finding a way to produce products more cheaply or to create products with characteristics consumers want. As Gregory Lee, CEO of Samsung said, “Relentless pursuit of new innovation is the key principle of our business and enables consumers to discover a world of possibilities with technology.”
An innovative firm knows that it will usually have a temporary edge over its competitors and thus an ability to earn above-normal profits before competitors can catch up.

Innovation isn't the profit machine you might think.

In certain cases, however, competition can discourage new technology, especially when other firms can quickly copy a new idea.
Consider a pharmaceutical firm deciding to develop a new drug. On average, it can cost $800 million and take more than a decade to discover a new drug, perform the necessary safety tests, and bring the drug to market. If the research and development, R&D, effort fails—and every R&D project has some chance of failure—then the firm will suffer losses and could even be driven out of business.
If the project succeeds, then the firm’s competitors may figure out ways of adapting and copying the underlying idea without having to pay the costs themselves. As a result, the innovative company will bear the much higher costs of the R&D and will enjoy, at best, only a small, temporary advantage over the competition.
Many inventors over the years have discovered that their inventions brought them less profit than they might have reasonably expected.
Eli Whitney invented the cotton gin, but then southern cotton planters built their own seed-separating devices with just a few minor changes from Whitney’s design. When Whitney sued, he found that the courts in southern states would not uphold his patent rights. Thomas Edison still holds the record for most patents granted to an individual. His first invention was an automatic vote counter, but despite the social benefits, he could not find a government that wanted to buy it. Gordon Gould came up with the idea behind the laser in 1957. He put off applying for a patent and—by the time he did apply—other scientists had laser inventions of their own. A lengthy legal battle resulted in which Gould spent $100,000 on lawyers before he eventually received a patent for the laser in 1977. Compared to the enormous social benefits of the laser, Gould received relatively little financial reward. In 1936, Turing delivered a paper titled, "On Computable Numbers, with an Application to the Entscheidungsproblem," in which he presented the notion of a universal machine—later called the Universal Turing Machine and then the Turing machine—capable of computing anything that is computable. The central concept of the modern computer was based on Turing’s paper.
A variety of studies by economists have found that the original inventor receives only one-third to one-half of the total economic benefits from innovations, while other businesses and new product users receive the rest.

Critical-thinking question

Can a company be guaranteed all of the social benefits of a new invention? Why or why not?

Want to join the conversation?

  • aqualine ultimate style avatar for user Ben McCuskey
    If the private sector tends to under invest in innovation does this mean that government occasionally needs to offer incentives to help drive innovation that might not otherwise occur in the private sector?
    (6 votes)
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  • old spice man blue style avatar for user Liam Mullany
    In a situation where innovation is easy to copy, and expensive to undertake (such as mobile phones) does a 'tradgedy of commons' exist? Whereby it is more profitable for a company to wait and copy someone else's innovation than to innovate themselves? Then if all companies adopt this approach innovation becomes 0!
    (2 votes)
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  • blobby green style avatar for user rmaas
    To what extent would these parameters change if the expectation were that social benefits would affect others vs. attempting to isolate it?
    (1 vote)
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