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Innovation, in an essential sense according Dosi (1988) “refers to the search for, and the discovery, experimentation, development, imitation and adoption of new products, new production processes and new organisational set-ups”. Innovation policy is used in the economy to promote economic growth and increase social welfare of a country, and according to Manjon and Merino (2012) patent seeks to serve this purpose. In the knowledge economy, there is an ever-growing dependency for innovation and it has also been argued by many economist that although the use of patents is essential to help the knowledge economy progress through incentives for innovation, several opposing school of thoughts have highlighted problems that patents create. This essay would aim to discuss the ends and means of innovation policy, and further evaluate the market failure and government failure framework and whether or not this policy performs well in the knowledge economy.
Innovation policy such as patent helps innovators or gives a legal right to exclude other people from using there invention. According to OECD (2012) the ultimate objectives of patent policy is to create dynamic knowledge and enhance the competitive advantage of a nation, improve standard of living by maintaining technological advancement. In research and development (R&D) patents are used to solve market failure of underinvestment. It is stated to be a public good, so therefore it is impossible to recover R&D investments and this leads to underinvestment below optimum level (Thompson, 2011). So for instance if an inventor uses his own knowledge to innovate, this would benefit him or her less compared to others, therefore social benefits counterweights private benefit. This alters government to intervene incentivise firms to improve the nation’s competitive advantages. Government intervenes by providing patents so as to inspire risk taking and investment in research and development (R&D). A patent system guarantees monopoly rights to inventors because it gives incentives to innovate (Hall, 2007). According to Arrow (1962) he believes that patent act as an effective barrier to accessing knowledge and do not solve the conundrum under perfect competition, an increase in the production of R&D is not guaranteed due to the huge costs of risks and failure –“Uncertainty and spillovers”. So provided that firms are given market power serves as means of insurance against those risks, by this means the government reassures innovation and technological development of the nation.
When one patents a technology all the information is revealed, this creates a diffusion of knowledge in an economy. It was stated that with patent protection, the inventor of the technology reveals the details of the technology to potential consumers but also in turn gets intellectual property rights. Henceforth, the point of patent policy is to create a positive externality of knowledge spillovers so that anyone can have the right to access the technology. These spillovers occurs because the innovators do not seem to see the effect that their research imposes on productivity of future research. As it is often assumed that existing or current knowledge would have a positive impact on creation of new knowledge, however this new knowledge contributes to economic growth. Patent also provides safety in time and space according to MacDonald (2003), it offers protection in time by allowing an inventor to have rights over his creation for a particular period of time. Due to uncertainty of demand the period of time is usually not long, there is fear that the product may not be demanded after a long time because there would be production of new technology, if one patent for long. While a protection in space allows an innovator to be protected in a particular place, for example an innovator patens in the United States, the inventor has no right over his knowledge if someone outside the US copies it, only if the inventor gets patent in the country in which it was copied.
Hall (2007) discovers government failure is present as patent aims to encourage innovation by parties depending on size and wealth, rather than a selected few. The legal framework around patent undoubtedly shows different challenges for parties dependent on size and wealth, as most innovators benefit from the presence of patents compared to others. Hall (2007) finds that smaller firms would be discouraged from entering a market because of threats of legal actions against them and this would result to a decline in research and development (R&D) from their perspective. Patent provides wealthier parties with an opportunity to legally threaten other inventors with smaller wealth or who face higher opportunity cost if they are to emphasis attention on a patent suit. Relative to wealthier parties, smaller firms would face a much larger cost if they take legal actions against a competitor. In doing so, less wealthy parties would have little incentives to innovate if they are not able to legally challenge other parties for contravention because of the high sunk costs involved. In contrast, it is believed that smaller parties who have ‘little to lose’ are likely to contest larger parties who have high sunk cost at risk.
Furthermore, Moser (2013) argued that patents do create a trade-off between the incentive for innovation and consumer welfare loss incurred due to a monopoly effect. Patent faces a major problem due the struggle involved in defining the technological space a patent covers, resulting to two or more firms overlapping in technological space when firms hold patent. A party may hold a patent without having a legal ownership of the technology or innovation that has been patented and this may make the two overlapping firms patented unable to manufacture or invent anything due to the legal risk involved. Both parties may feel intimidated by one another, and to ensure legal dispute do not ensue they avoid production. Additionally, both parties halt innovation totally, because the property right granted by the government may not cover them in a legal dispute properly. Due to their patent application being broad and poorly defined, Moser (2013) discovers that patentees are able to hold up rival firms from innovating and progressing. The society is therefore unable to benefit from either parties due to the overall lack of production and innovation, as most of these firms did not manufacture anything but held patents for legal reasons.
Also, patent are extolled as a key to innovation in a knowledge economy but yet there are historical evidence that indicates most innovation occurs outside of a patent system. Countries that lack patent system tend to produce an equal number of invention than countries who partake in patent system, and these invention were mostly of equal quality (Moser, 2013). In the UK, OECD (2005) showed an empirical evidence that innovation has negatively affected competitions instead of improving it. As stated above there is a trade-off due to the monopoly power gained by firms which is a disadvantage to them and this is because in the short run it provides monopoly rights to innovators and enhance their private returns, this also leads to under-utilisation of existing innovation in the long run (Thompson, 2011). When a patent diverts to monopoly power, producers tend to increase price and lower output compared to how it should be if the markets were competitive. This however shows that by transferring consumer surplus to producer surplus through dead weight loss, monopolies lead to rent seeking. Monopolies also reduces competitions and this slows the pace of technological progress, because the property rights that are used to encourage innovation in process distort competition by affecting the level of competition in a frim and this can mislead the efficient allocation of resources as completion is regarded as a main source of economic growth. This distortion of competition only occurs as a result of the time for a protection of a patent. If the protection of a patent is too long or too broad, it lead to government failure. The US intellectual property right for instance broadened the protection till the extent patents for software and business models were allowed, and this led to government failure in the economy as it hindered technical means that could aid people avoid encryption of work of arts (Dolfsma, 2011).
In conclusion, Key determinants of innovation are secrecy, lead-time, competition and technological progress. But in some cases patents contributes to a fall in innovation, increase social welfare loss, shows government and market failure. This essay has discussed the ends and means of innovation policy in a market failure versus government failure frame work, showing how the usefulness of a patent system may or may not work well in the knowledge economy due to government failure. It encourages incentives to take risks by assuring protection but has problems with consumer, and how it also gives a rise to trade-off between competition and monopoly.
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Thomson (2012) ‘Economic Perspectives on Innovation’. Australian Economic Review 44(4): 480-489.
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