Thursday, August 13, 2009

Free Market Science vs. The Free Rider Problem

11912hby Ryan Faulk

The free rider problem as it pertains to scientific research is as follows:

Company A spends $100K on developing a product, but company B can spend $10K and copy it, having the exact same product. Thus research and development is punished on a free market. That's the theory.

Edwin Mansfield, the late economist at the University of Pennsylvania came to the conclusion that in OECD countries, across all industry it costs $65 dollars to copy $100 worth of research. Or 65%. But that's just direct cost.

In order for a company to copy research, a great example is the drug industry, they have to have smart people. If I gave you a viagra pill, would you be able to reverse engineer that? No, a company needs to have smart people who can do that, with the equipment, on hand if they want to copy. So there are sunk costs involved if a company wants to copy research. This isn't just copying your neighbor's scantron answers.

Also it takes time to reverse engineer a product, and in that window the company that made the original product enjoys a monopoly. The more complex the innovation, the more difficult it tends to be to reverse engineer, and the longer that company enjoys a monopoly.

Given the advantage of the temporary monopoly of the originator plus the sunk costs needed for copiers to be able to copy, copying research and doing original research tend to come out as equally profitable strategies. Private firms in OECD spent about 3% of the budget on research.

That said, all firms engaged in research both copy and do original research themselves. Because in order to copy, you must have smart people doing original research in that field, you've got to have guys in the know, and when one company makes a breakthrough, everyone else rushes to copy.

The reason copying a product and originating a product tend to be equally profitable is basic economics. Products are only released by firms if it's revolutionary enough to earn a profit that makes up for the cost of development. And in order to make a profit, it must be difficult enough to provide a period of monopoly for those costs to be recuperated.

Products which are only slightly revolutionary aren't as expensive to develop as products which are extremely revolutionary, but also tend to be easier to reverse engineer, resulting in a shorter monopoly period. If you're interested in more detail, I would recommend Terence Kealey's book.

When the state funds scientific research, there is crowding out. For every $1 spent on research, $1.25 less is spent on research in private firms according to Kealey. I have an idea why this might be: government jobs are more secure and have shorter hours than private jobs, and so a government job of $100K a year is worth more than a free-market job of $100K a year. Or more discretely, a government job of $100K a year is worth about as much as a private job of $125K a year. That's just my guess as to why government funding crowds out private funding at more than a 1 to 1 ratio.

Also, government funding often goes to military research, which can lead to innovations there's no denying that, but it is not connected to what individuals choose to buy with their own money but what the military wants. And what the military wants isn't always tied to what's the best for waging war - for example the air force continues to fund the research of piloted aircraft because that provides jobs for pilots, whereas UAVs are clearly the wave of the future. The limiting factor of the F-22 wasn't the airframe, it was how many g's the pilot could take.

Francis Bacon, a torturer and an embezzler, in 1605 put forward the idea that science is a public good based on pure research. That yes it is applied science that leads to immediate discoveries, but that applied science can only come from a pure research background, which the short-sighted marketplace will not provide to appropriate degrees, and thus the state must fund pure research.

Now as it turns out, the best way for a firm to come up with some profitable breakthrough is to engage in pure research, because science is unpredictable and that which deals with the most fundamental and open-ended concepts - pure research, tends to result in the most novelty and thus breakthroughs.

And even companies whose sole goal is to merely keep up with the bigger companies and sell knock-offs of popular drugs have to employ scientists, and those scientists have to stay in the loop doing pure research. And so everyone is engaging in pure research constantly.

Francis Bacon's idea of state-funded science was implemented in France but not in Britain. Britain didn't implement any state science program until World War 1, and the United States didn't do very much at all until 1940.

Now one can always come up with many anecdotes about government funding of things causing that thing to come about, a great example that statist hack Noam Chomsky likes to bring up is the internet. As though connecting computers over long distances was something only state research could come up with. Sure, private research invents the airplane, automobile, about half of the computer, but connecting those computers together is a job for the state.

And on the airplane, at the time of the wright brothers, the Smithsonian was attempting to fly a heavier-than air craft as well. They were beat to it by the wright brothers.

Now just imagine if the Smithsonian had won, we wouldn't hear the end of it. "Oh, without the munificent foresight of state research planners, how would we have ever achieved heavier than air flight!" And the statists would make up arguments about the free market being unwilling to take such abstract risks or not being able to crash expensive airplanes repeatedly, and may even point and laugh at the wright brothers and say "look, there's your free market, two wacko brothers. Look at this clown show. What a failure! Maybe this crapshoot worked in 1000 AD, but look at how complex this things are now. Sure the free market worked then, but so did hunting with spears with spears. We're evolved, it's civilization. Enjoy your airplane, courtesy of the US government. Free market fundamentalist, you got pwned."

Anecdote. The state is not necessary to fund research and development, and from every angle of analysis, the state appears to pervert and distort the structure of production, in this case the production of scientific research.

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