The Free Market Innovation Machine: Analyzing the Growth Miracle of Capitalism.

• Author: Field, Alexander J.
• Position: Book Review

By William J. Baumol Princeton, N.J.: Princeton University Press, 2002. Pp. xiii, 318. $35.00 cloth.

The thesis of William J. Baumol's latest book is articulated clearly at the start. The free-market growth engine depends ultimately on institutional rules. People may have a natural entrepreneurial instinct, but that instinct can find outlet in criminal, rent-seeking, or other destructive activities as easily as in productive venues. Economic growth depends, however, on more than just rules and norms that channel such inclinations in the "right" direction. It depends also on rules governing the appropriation of intellectual property and on the precise trade-off a society makes between pricing information at its marginal cost (making it free) and providing incentives for invention and innovation by creating rules to allow appropriability for fixed periods of time. We call this body of rules patent, copyright, and, in general, intellectual property law (although, as Baumol argues, antitrust law is also relevant). The dilemma is that in the absence of such protection there are few private incentives for producing new information or discoveries, but in the presence of such protection we impose monopoly pricing and, consequently, static efficiency losses.

The first section of the book, devoted to the "capitalist growth mechanism," is the most interesting. Here Baumol develops his vision of a capitalist economy as consisting of a competitive price-taking sector and an oligopolistic sector in which competition occurs more often on the innovation margin rather than on the price margin. The pharmaceutical and computer industries are cases in point. This oligopolistic sector is the economy's engine of growth. Firms here must innovate or die; they also must price discriminate or die because the heavy fixed costs of innovation cannot be covered if everyone pays a price equal to marginal cost. These costs must be recouped in the same way that railroads were forced to price discriminate to cover their fixed costs for rolling stock and permanent way. Baumol cautions antitrust authorities against jumping to the conclusion that departures from marginal-cost pricing are necessarily evidence of monopoly power.

One of the unanswered questions in this book is whether our existing institutions and industrial organization create too many or too few incentives for innovation. It has been assumed commonly that there are too few incentives because of the divergence...