Capitalism, every undergraduate student of economics learns, thrives on competition. The brilliant virtue of the invisible hand of competition is that it forces firms to reduce costs, cut prices and thereby enrich consumers. This engaging tale has buttressed every economics narrative since Adam Smith lucidly explained more than 200 years ago how competition channels the natural greed of individuals into serving the social good.
Now William Baumol, an economics professor at New York University, wants to rewrite the basic tale. Yes, competition creates wealth. But in his new formulation, price cutting becomes a sideshow. Innovation takes center stage as the "primary weapon of competition." And the key to innovation is a clever form of collaboration among rivals.
Innovation, the process of translating inventions and new ideas into commercial products, is largely responsible for the tenfold rise in the living standards of American families over the last 100 years, he says in a new manuscript. Baumol's contribution is not to emphasize the impact of innovation but to pinpoint how competition forces companies to make innovation routine, much as marketing and advertising are. In Baumol's analysis, capitalism emerges as a system that hums because it has figured out how to make innovation humdrum. Baumol shows how companies pour money not only into their own research and development but also into such operations by their rivals. Yes, their rivals. Firms participate in joint ventures that hire teams of researchers to develop technologies that the firms will share. They also engage in the largely unrecognized practice by which companies enter into technology-sharing compacts. Under these compacts, a company like IBM writes contracts with competitors, like Hitachi. The companies promise to license future innovations to each other for a set fee. That way, if Hitachi comes up with a spiffy next-generation disk drive, IBM is guaranteed the right to incorporate Hitachi's new drive in its own computers. It might seem odd for an economist like Baumol to herald collaboration among potential competitors. By jumping into the arms of rivals, companies appear to dull their incentive to innovate on their own. After all, if they can imitate rivals, why bother to innovate on one's own? To understand Baumol's point, put yourself in the place of IBM. You could try to piggyback off Hitachi's innovations, dismissing your own engineers. But that strategy would collapse. At the very least, you would be dishing out hundreds of millions of dollars each year to rivals without getting anything in return. Worse, Hitachi would soon drop the agreements, because they make sense only if it expects to get about as many new products from IBM as it provides to IBM. Nor would it make economic sense to beef up your investment in innovations without entering technology-sharing contracts. If four or five of your major rivals share innovations among themselves, then they will generate lots of ideas, drowning out the efforts of your one research department. And anything you don't figure out on your own will be offered to consumers by all your rivals. You simply cannot afford to bear that risk. The compacts eliminate the threat that a misstep in the technology race will drive you out of business. Besides, Baumol says, the compacts generate licensing fees that have become "a substantial business activity in itself." Baumol's analysis makes a bigger point, far beyond the benefits and costs to individual companies. Technology-sharing contracts also help the economy -- that is to say consumers -- by spreading the benefit of innovation far beyond the customers of any one company. You don't have to buy Hitachi to get the benefit of its breakthroughs. Drawing on his career as a consultant as well as scholar, Baumol says "that of the 20 or so firms that engage in substantial research and development for whom I have consulted over the past few years, almost all had technology-sharing agreements of one sort or another with other firms in their industries. …