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
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
in the living standards of American families over the last 100
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
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
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
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,
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
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
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. …