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Here we'll explore the various economic and financial principles that impact the business of technology, keeping up to date on the various ideas, theories, trends and numbers, dispelling the silly buzzwords, slogans and fads and generally trying to understand how recent developments affect this industry going forward and may help divine what's going on and where things may be headed. Among the topics we'll touch on: regulatory issues, intellectual property, network effects, the general economy, productivity and more.

About this editor

Arnold Kling has a Ph.D. in economics from MIT; founded homefair.com, one of the very first commercial websites, in 1994; separated from Homefair in January 2000 after it was sold to Homestore; is author of Under the Radar: Starting Your Internet Business without Venture Capital

and is an essayist. Please send any comments, as well as suggestions for what we might point to from this page, to us at econ@corante.com

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By Arnold Kling

Creation vs. Distribution in the Front-Loaded Economy:
Information Wants to be Free, but People Still Need to Get Paid

1:02 pm

By Arnold Kling

Creation vs. Distribution in the Front-Loaded Economy: 

Information Wants to be Free, but People Still Need to Get Paid

In today's economy, value is being created by undertaking research and development.  This in turn leads to solutions that cost relatively little in terms of traditional factors of production.  Incentives are needed in order to promote research and development.  However, if marginal efficiency were the over-riding consideration, goods and services would be free or nearly so.  Thus, we have the paradox that (the distribution of) information wants to be free, but people who engage in research and creation need to get paid.  New economic arrangements, including broad-based clubs and research prizes, need to be developed.

In the Internet era, many of the most bitter struggles over commerce and policy are being fought because of the potential to offer valuable goods and services for free. For instance:

  • The Microsoft anti-trust case centers around the decision by Microsoft to distribute the Internet Explorer browser at no charge.

  • Napster became the flashpoint in a war over music distribution by offering music-swapping service for free.

  • The champions of Wi-Fi argue that new protocols and receiver technologies make it possible to deliver high-speed wireless Internet service at essentially no marginal cost.

Beyond these immediate cases loom several other issues of products and services where research and development costs are high, but the marginal cost of the final product or service is low.

  • The marginal cost of manufacturing prescription drugs is low. Our traditional policy has been to allow drug companies to recoup their research and development costs by giving them patents that enable them to charge prices for drugs that are far above marginal cost. This policy has come under fire with the AIDS crisis in Africa and more recently with the Anthrax scare in the U.S.

  • The bioinformatics revolution promises to bring about medical treatments that have high benefits and extremely low marginal cost, but only after difficult and extensive research.

  • The cost of data storage, search, and retrieval keeps falling.

  • The cost of food production, which has been falling for centuries, could approach zero with bio-engineering of crops.

  • In a recent online interview, inventor Ray Kurzweil says,

    the knowledge component of products and services is asymptoting towards 100 percent. By the time we get to 2030 it will be basically 100 percent. With a combination of nanotechnology and artificial intelligence, we'll be able to create virtually any physical product and meet all of our material needs.

The Front-Loaded Economy

Welcome to what we might call the "front-loaded" economy.  That is: an economy in which most of the expenses involved in providing goods and services are front-loaded in the form of research and development - once the product or service has been designed, it can be provided at a marginal cost at or near zero.

In the front-loaded economy, there is a case for consumers to expect goods and services for free.  Consumers--who think that they should be able to swap songs for free, use pirated software, or obtain medicines at a competitive price without paying a markup to patent holders--are not entirely wrong.  The most efficient allocation of goods and services is obtained when the price is equal to marginal cost--and if the marginal cost is zero, so be it.

On the other hand, musicians, software programmers, and drug researchers--who think that they are entitled to compensation for their efforts to obtain and apply their skills--are not entirely wrong.  If research and development is not rewarded, then there is no reason to expect people to create the most valuable products and services.

The Role of Government

The front-loaded economy raises issues of public policy that may exacerbate the polarization between liberals and conservatives. For those who tend to view government as an instrument of the public good whenever the free-market outcome may be flawed, the front-loaded economy begs for more government intervention. For those who tend to see government as providing an instrument by which status quo interests can impede change, the front-loaded economy is a reason for keeping government hands off.

Liberals consider the role of government in the front-loaded economy and see opportunities.

  • In the absence of government involvement, one person's research can be appropriated by someone else. This would deny any reward to researchers. The only economic ways to encourage research and development are (a) direct government funding and (b) defining and enforcing patent law. The better job the government does with these functions, the better will be the outcomes.

  • It is not efficient for prices to be set far above marginal costs. When the marginal cost of drug therapy or wireless Internet service is set artificially high, there will be pressure on government to do something to correct the mispricing.

Conservatives consider the role of government in this environment and see threats.

  • Government is traditionally slow to recognize and shut down failures. The private sector is better at the sort of trial-and-error learning that is required for applied research.

  • Private-sector competition is what allows cost-saving innovations to deliver benefits to consumers.

  • Innovation is disruptive. In a disruptive situation, government tends to become aligned with the opponents of change. For example, recent legislation concerning intellectual property has strongly favored traditional music and movie distributors at the expense of innovation and consumer benefit.

New Economic Arrangements

Our existing economic arrangements may not be adequate to address the issues posed by the front-loaded economy.   I fear we could get stuck in an unproductive tug-of-war between producers and consumers over issues of copyright, patent, and licensing.

New arrangements are needed in order to resolve the paradox that information wants to be free but people need to get paid.  Possible arrangements include:

  • Flexible licensing, as advocated by Lawrence Lessig's initiative for a Creative Commons
  • Broad-based clubs, as I have described.
  • Rewarding innovations with dollar prizes instead of patents.  Prizes could be funded by taxpayers, with rules for the size of awards based in part on the extent to which the innovation is employed.

Whatever new arrangements emerge, we can predict that they will do two things.  First, they will reduce marginal cost to consumers for goods and services.  Second, they will provide rewards to those who engage in research and creativity.

* * * * *

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