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Innovation and Productivity: Using Bright Ideas to Work Smarter - TPRP 08/05

Knowledge is an unusual economic good and this has important implications for institutions and policy[4]

Knowledge in an economic context can be thought of as a type of instruction or recipe that sets out how a good or service can be produced. Innovation, on the other hand, is “the successful development and application of new knowledge” (OECD, 2005).

Using the definition of knowledge as an instruction or recipe, we can turn to look at some of the key characteristics of knowledge, and the implications of these characteristics.


The most important characteristic of knowledge is non-rivalry, which means that one person’s use of an idea does not preclude another person using it at the same time

From an economic perspective, the most important characteristic of knowledge is non-rivalry, since it is this characteristic that implies increasing returns to scale in production and the potential for knowledge spillovers.

Non-rivalry simply means that one person’s use of the good does not diminish another’s use. As Jones (2004) puts it: “Once the design of the latest computer chip has been invented, it can be applied in one factory or two factories or ten factories. The design does not have to be reinvented every time a new computer chip gets produced.”

Jones (2004) (referencing Romer, 1990) provides a simple illustration of how non-rivalry leads to increasing returns to scale. As a simplified representation, we can think of a firm as something that produces output from a number of inputs – knowledge, capital, labour, and so on. The key point is that we need only double the standard inputs (capital, labour, etc) to double the amount of output. We do not need to double the stock of knowledge because knowledge is non-rival: the existing chip design can be used in the new factory by the new workers. However if we do double the existing stock of knowledge (in addition to doubling the standard inputs), the output will more than double, ie we get increasing returns to scale.[5]

Increasing returns to scale can create problems for competitive markets to reach the best outcome for society. When competitive markets work well, they do so by decentralising millions of input-output decisions to individual workers and firms. But if there are increasing returns to scale then competitive markets could result in harmful monopoly, suboptimal provision, or coordination problems that prevent a new industry emerging.[6]

Fixed and marginal costs

Coming up with a good new idea typically costs resources (often significant resources) but subsequent uses of the idea are possible at zero marginal cost, since it can be simultaneously used by many people or firms. We can say that the new piece of knowledge has an initial high fixed cost but low constant marginal costs with respect to repeated uses of the idea. This is another way of describing increasing returns to scale.

It is important to note that while the marginal cost of production (or use) of an existing idea is zero, this does not necessarily imply that transmission of the idea is costless. For example, think of a design for a computer chip, which is transmitted via a blueprint. Additional copies of the blueprint might be required, and these have a cost and are rivalrous – so would be included as standard inputs in the simplified representation of a firm above.


Another important characteristic of knowledge is the inability to exclude others from using it, though the degree of excludability will vary according to a number of factors

Another characteristic often attributed to knowledge is non-excludability. Non-excludability means that once a good has been created, it is impossible to prevent other people from gaining access to it (or more realistically, is extremely costly to do so).

While non-rivalry is an inherent feature of knowledge, it makes sense to think of non-excludability as more of a continuum, with the degree of excludability varying depending on a range of factors. These include:

  • the observability of the knowledge (for example, the process for manufacturing a product may be more excludable than the design);
  • the legal and regulatory environment;
  • the state of technology; and
  • the characteristics of both imitators and knowledge creators.

If knowledge is not perfectly excludable, others can benefit from the knowledge other than the creator. The knowledge “spills over” to others – a positive externality. This outcome is good from a social point of view, because the benefit to society as a whole outweighs the loss of potential economic rents the creator could have made from keeping the knowledge to herself (because knowledge is non-rival). However, the creator’s ex post inability to capture enough of those rents will diminish the incentive to invest in developing knowledge in the first place.

Neither perfect excludability nor perfect non-excludability is likely to result in the socially optimal outcome

An important insight then is that while excludability solves one of the problems of knowledge (giving creators of new ideas an incentive) it generates another one by restricting the dissemination of knowledge. Consequently, neither perfect excludability nor perfect non-excludability is likely to result in the socially optimal outcome. Thus there is a fundamental tension between incentives to create knowledge and incentives to disseminate it.

In the New Zealand context, this discussion should also consider that the majority of world knowledge is created abroad. For example, strengthening excludability in New Zealand (eg, through IP rights) could increase incentives for New Zealand firms to innovate, but could also make it more difficult for New Zealand firms to make use of innovations developed overseas.


  • [4]This section largely draws on Blakeley, Lewis and Mills (2005) to which the reader is referred for more detailed discussion of the characteristics of knowledge as an economic good.
  • [5]It may not be intuitively obvious what “doubling the stock of knowledge” means in practice. Clearly it is not identical to doubling standard inputs like labour – rather we can think of it as doubling the number of useful ideas or simply developing new and better ideas. It is common practice in empirical studies to estimate a “stock” of knowledge based on the flow of new knowledge through research and an estimate of depreciation on existing knowledge.
  • [6]More technically, increasing returns to scale can also give rise to problems because of the possibility of non-existence of a competitive equilibrium – or the existence of multiple equilibria, some of which will be inferior (in terms of efficiency) to others.
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