The Failure of Market Failure | #4 | Venture Capital in the 21st Century

Summary

This lecture explores the role of the state in the innovation economy, particularly in funding and promoting research and development (R&D). It examines market failures, the contributions of economists like Nelson and Arrow, and the importance of state interventions in addressing innovation challenges. The historical context of state-driven technological advancements, particularly through military funding, highlights the vital partnership between the public and private sectors. The discussion emphasizes how national security needs and economic development have driven state involvement in innovation, rather than market failure alone, ultimately shaping the modern innovation landscape.

Takeaways

• 😀 Welfare economics examines market failure and the role of the state in correcting inefficient resource allocation, especially in innovation.
• 😀 Richard Nelson's work questions how much should be spent on basic research, identifying the possibility of positive externalities that justify state intervention.
• 😀 Nelson rejects the neoclassical view of market failure, arguing for an evolutionary economics approach to understand innovation dynamics.
• 😀 Markets may not fail when gains from invention are obvious, but as we move upstream to basic research, uncertainty about returns creates the need for public funding.
• 😀 Kenneth Arrow identified three key causes of market failure in innovation: increasing returns, inappropriability, and uncertainty regarding future inventions.
• 😀 Arrow’s work, in collaboration with Gerard Debreu, demonstrates that a general market equilibrium is unattainable due to the absence of complete markets.
• 😀 While monopoly rents fund innovation, they also reduce the incentive for firms to innovate, highlighting the paradox of market failure corrections through imperfect competition.
• 😀 Empirical studies show that private firms underinvest in R&D, necessitating public funding to bridge the gap between social and private returns to innovation.
• 😀 State intervention in innovation has often been driven by national security goals, as seen in historical examples like the U.S. military's role in mass production technologies.
• 😀 The post-WWII U.S. government invested heavily in R&D, especially through defense funding, which played a key role in advancing technological innovation.
• 😀 The state's role in fostering innovation is more aligned with national objectives, like security, than simply correcting market failure, as evidenced in historical cases like the development of Silicon Valley.

Q & A

What is the main focus of welfare economics as discussed in the script?

Welfare economics primarily studies market failure and the inability of markets to efficiently allocate resources. It focuses on how state interventions may correct these failures, especially in relation to technological innovation and research funding.

How does the state's role in innovation economy complement financial speculation?

The state funds upstream investments in science, which have uncertain returns, and enables the commercialization of innovations. This complements financial speculation, which drives innovation through speculative investments but without guarantees of returns.

What significant question did Richard Nelson ask in his paper, and how does it relate to state funding of research?

Richard Nelson asked 'How much should we spend on basic research?'. He argued that markets might not provide sufficient funding for basic research due to its uncertain returns, and thus the state could intervene to correct this market failure.

Why does Nelson argue against the neoclassical approach to market failure and innovation?

Nelson rejects the neoclassical approach because it fails to account for the complex dynamics of innovation. Instead, he advocates for an evolutionary economics approach, which better captures the uncertain and non-linear nature of technological innovation.

How did Lord Rothschild's analysis of UK innovation policy distinguish between research types?

Lord Rothschild proposed a clear line between basic research, which should be funded by the state, and applied research, which should be funded by the private sector. However, Donald Stokes later challenged this distinction, pointing out that basic research can often have applied outcomes, like Pasteur's fermentation research.

What is Kenneth Arrow's contribution to understanding market failure in innovation?

Kenneth Arrow highlighted three main sources of market failure: increasing returns to capital or labor, inappropriability (where funders cannot capture all returns), and uncertainty about future goods. His work also emphasized the challenge of achieving general market equilibrium, particularly with incomplete markets.

What role do patents and public funding play in the innovation economy?

Patents that cite public funding have increased since World War II, particularly those awarded to corporations. This demonstrates the growing interdependence between public and private sectors in R&D. However, the decline in corporate investment in upstream science raises concerns about the balance of public and private funding in innovation.

How does the empirical research quantify the difference between social and private returns on R&D?

Empirical research has found that the marginal social return on R&D is significantly higher than the private return, with estimates suggesting social returns are nearly three times greater than private returns. This highlights the importance of public sector involvement in funding innovation.

What historical examples show that state intervention in innovation was driven by factors other than market failure?

Historical examples, such as the British military demand for guns in the 18th century and the U.S. Department of Defense's role in the digital revolution, show that state intervention was often motivated by national security concerns, rather than purely market failure.

How did the U.S. Department of Defense contribute to the innovation economy?

The U.S. Department of Defense played a central role by funding research and development, which led to significant technological advances, such as the creation of the internet and other digital technologies. The DoD also served as a key customer, driving demand for innovations that later had broader commercial applications.