microeconomicsI’m reading a paper and it states that monopolies encourage innovation, but I don’t understand why. Could you give me a brief explanation?
One argument for how a monopoly encourages innovation, is that if a particular innovation is expensive to discover, but cheap to copy, then an investor would only invest in discovery, if they could be sure that the invention would not be copied once discovered, as that would erode the profit margin to such a degree that the returns no longer make the investment worthwhile.
This sort of argument is typically given to justify the temporary monopolies granted to copyright holders of creative works, and to patent holders of inventions.
The argument’s validity rests on the (often untested) assertion that the aggregate social welfare of higher innovation with excess monopoly profits is greater than the aggregate social welfare of lower innovation without excess profits.
The British East India Company is proving a fertile source for historians contemplating the experiences of monopolies (and, state-supported champions in particular):
Both the Company and its modern descendants serve two masters, keeping one eye on their share price and the other on their political patrons. Many of today’s state-owned companies are monopolies or quasi-monopolies: Brazil’s Petrobras, China Mobile, China State Construction Engineering Corporation and Mexico’s Federal Electricity Commission, to name but a few of the mongrel giants that bestride the business world these days. Many are enthusiastic globalisers, venturing abroad partly as moneymaking organisations and partly as quasi-official agents of their home governments. Many are keen not only on getting their government to provide them with soft loans and diplomatic muscle but also on building infrastructure—roads, hospitals and schools—in return for guaranteed access to raw materials. Although the East India Company flourished a very long time ago, in a very different world, its growth, longevity and demise have lessons for those who run today’s state companies and debate their future, lessons about the benefits of linking a company’s interests to a nation’s and the dangers of doing so.
From The Economist, The Company that ruled the waves.
The Company was certainly innovative:
The Company’s success in preserving its animal spirits owed more to necessity than to cunning. In a world in which letters could take two years to travel to and fro and in which the minions knew infinitely more about what was going on than did their masters, efforts at micromanagement were largely futile. The Company improvised a version of what Tom Peters, a management guru, has dubbed “tight-loose management”. It forced its employees to post a large bond in case they went off the rails, and bombarded them with detailed instructions about things like the precise stiffness of packaging. But it also leavened control with freedom. Employees were allowed not only to choose how to fulfil their orders, but also to trade on their own account. This ensured that the Company was not one but two organisations: a hierarchy with its centre of gravity in London and a franchise of independent entrepreneurs with innumerable centres of gravity scattered across the east.
And:
The Company repaid the state not just in taxes and tariffs, but also in ideas. It was one of the 18th and 19th centuries’ great innovators in the art of governing—more innovative by some way than the British government, not to mention its continental rivals, and outgunned only by the former colonies of America. The Company pioneered the art of government by writing and government by record, to paraphrase Burke. Its dispatches to and from India for the 15 years after 1814 fill 12,414 leather-bound volumes. It created Britain’s largest cadre of civil servants, a term it invented.
The requirement for innovation was not as a result of their monopoly of the UK market, but their competition with other state-directed firms around the world. Chinese oligopolies today compete with Russian, Brazilian, Korean and Indian state-protected champions.
None of this means that such champions are a good idea. There are still dangers from such companies, not least because they become unelected government entities with unaccountable executives.
How could it justify having a monopoly of trade as well as the right to tax the citizens of India? And how could a commercial organisation justify ruling 90m Indians, controlling 70m acres (243,000 square kilometres) of land, issuing its own coins, complete with the Company crest, and supporting an army of 200,000 men, all of which the East India Company did by 1800? Adam Smith denounced the Company as a bloodstained monopoly: “burdensome”, “useless” and responsible for grotesque massacres in Bengal.
Chinese companies are finding themselves taking on greater local-government responsibility in the parts of Africa where they do business. This makes them unpopular and increases their exposure to non-business risk.
It is not that state-supported monopolies can't be competitive when forced to tussle for the same consumers as other state-supported monopolies, it is that they are unaccountable and disrupt the common law.
Patents are not really monopolies. A monopoly, like existed in the US with the Telecom industry until deregulation in the 80’s, one company dominates and excludes other companies from competing by denying them access to the market. A patent simply protects an invention for a limited time so that the inventor is the only one able to legally produce the product. That does not prevent another company from inventing another product that does something similar or even better.
This protection allows companies to make innovative products and reap the rewards. It opens new markets that did not exist before. In 1980 we had 4 of the same rotary phone in different colors in our house. The technology was the same as it was in 1970. We could not go buy a new phone at the store (unless it was an AT&T store). There was no effort to innovate because AT&T would not let you use the new products on their network.
By 1990 that had changed because AT&T saw the wireless wave coming so they surrendered their monopoly on Telecom so they could innovate and compete in the future. The industry exploded. Apple released their iPhone in 2007. They still have a monopoly on the iPhone. But because the marketplace is open other smart phones have popped up to compete. That is the difference between a true monopoly where competition is stifled and a patent that protects the original work but encourages others to create something similar and to improve.
The US Bell telephone system was a de facto monopoly. The monopoly was given regulatory support with the requirement that Bell spend a fraction of its earnings in R&D. Bell labs was a world leading source of innovation for decades. So there is some truth to the statement.
Was there more or less innovation under the Bell monopoly then there would be without it? Would there be more innovation if the Bell monopoly had persisted? It is hard to know. Unfortunately these questions tend to be answered according to ideology rather than scientifically or with attention to facts. A previous answer mentioning the Bell telephone system is a good example.
I would say that the preponderance of economists who study the subject, as well as the engineers who actually do the innovative work, would say that more innovation occurs under a competitive regime than under a long-lasting monopoly. Those who still remember the late Soviet Union would tend to agree. However, exceptions do exist.
No. Monopolies can’t encourage innovation because people lose hope. If there is a monopoly everyone is hopeless.
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