idealized competitive market. There are many forms of market failure—departures from this ideal. Two of the most important are monopolistic control of specific goods and incomplete property rights. Many discussions treat research as a public good and presume that the underlying market failure is one of incomplete property rights. This suggests that if we could make the protection for intellectual property rights strong enough, we could return to the competitive ideal. In fact, a true public good is one that presents policymakers with an unavoidable choice between monopoly distortions and incomplete property rights.

There are two elements in the definition of a public good. It must be nonrival, meaning that one individual’s consumption of the good does not diminish the quantity available for others to use. It must also be nonexcludable. Once it is produced, anyone can enjoy the benefits it offers, without getting the consent of the producer of the good (3).

Incomplete excludability causes the kind of market failure we expect to observe when property rights are not well specified. When a rival good such as a common pasture is not excludable, it is overused and underprovided. Society suffers from a “tragedy of the commons.” The direct way to restore the conditions needed for an efficient outcome is to establish property rights and let a price system operate. For example, it is possible to divide up the commons, giving different people ownership of specific plots of land. The owners can then charge grazing fees for the use of the land. When there are so many landholders that no one person has a monopoly on land, these grazing fees give the owners of livestock the right incentives to conserve on the use of the commons. They also give landowners the right incentives to clear land and create new pasture. When it is prohibitively expensive to establish property rights and a price system, as in the case of fish in the sea, the government can use licensing and quotas to limit overuse. It can also address the problem of underprovision by directly providing the good, for example by operating hatcheries.

For our purposes, the key observation is that these unmitigated benefits from property rights are available for rival goods. Nonrival goods pose a distinct and more complicated set of economic problems that are not widely appreciated. Part of the difficulty arises from the obscurity of the concept of rivalry itself. The term rival means that two persons must vie for the use of a particular good such as a fish or plot of land. A defining characteristic of research is that it produces nonrival goods—bits of information that can be copied at zero cost. It was costly to discover the basic information about the structure of DNA, but once that knowledge had been uncovered, unlimited numbers of copies of it could be made and distributed to biomedical researchers all over the world. By definition, it is impossible to overuse a nonrival good. There is no waste when every laboratory in the world can make use of knowledge about the structure of DNA. There is no tragedy in the intellectual commons. For a detailed discussion of nonrivalry and its implications for technology development, see Romer (4).

Some of the most important science and technology policy questions turn on the interaction of excludability and rivalry. As noted above, for a rival good like a pasture, increased excludability, induced by stronger property rights, leads to greater economic efficiency. Stronger property rights induce higher prices, and higher prices solve both the problem of overuse and the problem of underprovision. However, for a nonrival good, stronger property rights may not move the economy in the right direction. When there are no property rights, the price for a good is zero. This leads to the appropriate utilization of an existing nonrival good but offers no incentives for the discovery or production of new nonrival goods. Higher prices ameliorate underprovision of the good (raising the quantity supplied) but exacerbate its underutilization (diminishing the quantity demanded). If scientists had to pay a royalty fee to Waston and Crick for each use that they made of the knowledge about the structure of DNA, less biomedical research would be done.

The policy challenge posed by nonrival goods is therefore much more difficult than the one posed by rival goods. Because property rights support an efficient market in rival goods, the “theory of the first best” can guide policy with regard to such goods. The first best policy is to strive to establish or mimic as closely as possible an efficient market. For nonrival goods, in contrast, policy must be guided by the less specific “theory of the second best.” For these goods, it is impossible, even in principle, to approach an efficient market outcome. A second best policy, as the name suggests, is an inevitable but uneasy compromise between conflicting imperatives.

The conceptual distinction between rivalry and excludability is fundamental to any discussion of policy. Rivalry is an intrinsic feature of a good, but excludability is determined to an important extent by policy decisions. Under our legal system, a mathematical formula is a type of nonrival good that is intentionally made into a public good by making it nonexcludable. Someone who discovers such a formula cannot receive patent or copyright protection for the discovery. A software application is another nonrival good, but because copyright protection renders it excludable, it is not a public good. It is correct but not very helpful to observe that the government should provide public goods. It does not resolve the difficult question of which nonrival goods it should make into public goods by denying property rights over these goods.

Beyond “the Market Versus the Government.” In many discussions, the decision about whether a good should be made into a public good is posed as a choice between the market and the government. A more useful way to frame the discussion is to start by asking when a pure price system (which may create monopoly power) is a better institutional arrangement than a pure tax and subsidy system, and vice versa.

By a pure price system we mean a system in which property rights are permanent and owners freely set prices on their goods. Under such a system, a firm that developed a novel chemical with medicinal uses could secure the exclusive rights to sell the chemical forever.

A pure tax and subsidy system represents a polar opposite. Under this system, the good produced is not excludable, so a producer cannot set prices or control how their output is used. Production would be financed by the subsidy. Produced goods are available to everyone for free. To clarify the policy issues that arise in the choice between these two systems, our initial discussion will be cast entirely in terms of a firm making internal decisions about investment in research, avoiding any reference to the public sector.

Financing Innovation Within the Firm. Picture a large conglomerate with many divisions. Each division makes a different type of product and operates as an independent profit center. It pays for its inputs, charges for its outputs, and earns its own profits. Senior managers, who are compensated partly on the basis of the profits their division earns, have an incentive to work hard and make their division perform well.

To make the discussion specific, imagine that many of the products made by different divisions are computer controlled. Suppose also that some divisions within the firm make software and others manufacture paper products, such as envelopes. Both the software goods and the paper products may be sold to other divisions. The interesting question for our purposes is how senior managers price these internal sales.

Producing Paper Products. For rival goods like envelopes, the “invisible hand” theorem applies to an internal market within the firm just as it would to an external market: a pure price system with strong property rights leads to efficient outcomes. An efficient firm will tell the managers of the envelope division that they are free to charge other divisions whatever price they want for these envelopes. Provided that the other divisions are free to choose between buying internally or



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