Innovation & market failure

Maynard Keynes famously said that the job of investing should not be left to the market. But can the same be said for research and development? This is the question raised by a new paper (pdf here) by Daron Acemoglu.He starts from a fact which is often trumpeted by admirers of the free market - that producers capture only a tiny fraction of the full benefits of innovative activity. This, he says, means that innovation will be misdirected. Imagine two products: say, a petrol car and an electric one. An innovation that slightly improves the petrol car can be marketed immediately and thus is profitable. However, a small innovation in electric cars merely makes them slightly less useless and so is less monetizable - although such innovations might be a necessary  stepping stone to further innovations which would make the car feasible. Innovative activity will therefore be directed towards the petrol car rather than the electric one. The result will be insufficient diversity in innovation:

The recognition that there will be further innovations will discourage research in areas that will generate new products or technologies for the future relative to improving currently used products, processes, or technologies. Consequently, in equilibrium, too much research will be devoted to currently successful product and technology lines.

Three things make me suspect that this problem could be especially pressing now:1. If there is a danger of catastrophic climate change, then there is a need for new green technologies. But the danger that producers won’t get the fruits of such innovations - as they’ll be usurped by future better innovations - can lead to under-investment in them.2. Capital spending and productivity growth have been weak for years. This might be a symptom of a decline in useful innovations. Maybe capitalism has picked the low-hanging fruit.3. Many innovations (pdf) since the 1980s have had the effect of increasing inequality. They’ve benefited capitalists and/or bosses at the expense of workers. So, what are the counterweights to insufficient diversity?One, says Acemoglu, is simple human nature. People differ in their interests and competences, and so might research fields which are a low priority from capitalists’ viewpoint. We might add to this the use of tax credits for R&D activity, and also the fact that capitalists tend to be over-confident and hence willing to invest in areas where the objective probabilities of success are low. In this context, there is a strong argument for universities’ research priorities being independent of commercial considerations; such independence is one way of promoting the diversity of research which pure market pressures might tend to reduce. It would of course be foolish to dismiss market forces as a tool for producing innovation: markets have a better record than state intervention at producing diversity. But we should ask whether there are policies which might make the market better in this regard. And this question should perhaps be a higher priority than it is.