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Knowledge is an unusual economic good and this has important implications for institutions and policy (continued)

Other characteristics

Knowledge is also characterised by a dependence on past knowledge, by uncertainty, and by long lags before practical application

A number of other characteristics of knowledge have been discussed in the literature, including the cumulative nature of knowledge, uncertainty, and lags.

Non-rivalry and non-excludability are sufficient to create the possibility of economic problems around knowledge. However, other characteristics of knowledge may add to the risk of suboptimal investment in knowledge production and dissemination. Below we briefly summarise the issues raised.

The Cumulative Nature of Knowledge

An important feature of knowledge is that it is an input not only into the production of final goods like pharmaceuticals and software, but also into the production of further knowledge. As Sir Isaac Newton famously said, “If I have seen far, it is by standing on the shoulders of giants”.

The cumulative nature of knowledge adds further to the (increasing) returns to investment in knowledge. It is another channel whereby new knowledge can benefit society and the overall benefits may be large, long-lived and widely dispersed across the economy (Nelson, 1959). In turn this increases the risk of under-investment in knowledge creation given the difficulty of identifying (and recouping costs from) the beneficiaries. It also implies that benefits are likely to be difficult to predict in advance, which adds to uncertainty around knowledge production.

Uncertainty and Lags

Both the production and distribution of knowledge are subject to considerable uncertainty and long time lags. By definition, firms involved in knowledge creation do not know exactly what they are attempting to produce, how best to achieve it, or even whether or not they will succeed. Similarly on the demand side, consumers of knowledge may not understand exactly what they are buying until after it is purchased. For these reasons, investment in knowledge creation is a highly risky undertaking and this may make it difficult to attract private funders, particularly when the project is closer to basic rather than highly applied research.

The presence of uncertainty does not of itself imply market failure, since markets have developed sophisticated contract mechanisms for dealing with risk allocation. However, these mechanisms are imperfect, work less well over very long time periods, and tend to be subject to moral hazard problems (for example, insurance against the risk of a research project not succeeding will adversely affect the researchers’ incentives to succeed). Uncertainty may be more problematic in the case of knowledge production than for other types of goods, due to the difficulties of assessing risk, measuring outcomes, and asymmetric information (Tisdell 1995). It is also likely to be particularly acute for basic research that is primarily an input into further knowledge.

Evidence on knowledge spillovers

The empirical evidence is quite consistent in showing that social rates of return to R&D are large and typically significantly higher than private rates of return

The most widely studied aspect of market failures around knowledge is knowledge spillovers from R&D, as measured by the social versus private returns to R&D activity. The private returns accrue to the specific firm that undertook the R&D, whereas the social returns additionally include returns to other firms throughout the economy. These studies are quite consistent in finding that:

  • the private rates of return to R&D are high; and
  • the social returns to R&D are higher than the private returns.

Good reviews of the empirical evidence can be found in Weiser (2005), Cameron (1998) and Grilliches (1992). Estimates of private rates of return to R&D generally fall in the 20% to 30% range. Studies of the spillover benefits from R&D on average yield estimates of spillovers that are around two times higher than private rates of return – thus giving total social rates of return (private returns plus spillovers) in the order of 90% to 100% (Weiser, 2005; Cameron, 1998; Griffith, 2000)[7].

The important point from a policy perspective is not the size of the private or social returns in isolation, but rather the difference between them

The most important point from a policy perspective is not the size of the private or social returns in isolation, but rather the difference between them. The source of any difference is attributable to spillovers - one of the main potential sources of market failure identified earlier. These spillovers and their large size suggest that the marginal social benefit to more R&D is higher than the marginal social cost.

While some investigators have questioned these results and cited contradictory findings, on balance the majority of the literature points in the direction of significant spillovers from R&D. After surveying measurement difficulties associated with observing R&D and its impact, Hall (1996) nonetheless states in her conclusion that there is “overwhelming evidence that some positive externalities exist for some types of R&D”.

Institutional and policy responses to the challenges of knowledge creation versus dissemination

Societies have developed a range of policies and institutions that at least partly overcome the tension between knowledge creation versus dissemination

The characteristics of knowledge outlined above – non-rivalry, together with a varying degree of non-excludability and other features such as uncertainty – suggest the possibility of market failures around knowledge, including spillovers and tensions between ex-ante incentives for creation and ex-post incentives for diffusion. Moreover, the empirical evidence of large spillovers from R&D indicates that these failures and consequent underinvestment in knowledge could be quite severe.

Given the importance for economic progress and human wellbeing of knowledge and innovation, it is not surprising that societies have developed policies and institutions that at least partly overcome the potential market failures associated with them. These include:

Intellectual property rights (IPRs) – while these incentivise knowledge creation they do so at the cost of giving monopoly power over the use of something that actually costs nothing (because knowledge is non-rival) for another firm or consumer to use. To limit this cost, IPRs are typically circumscribed. For example patents are time limited (perhaps 10-20 years), require the holder to publicly disclose the nature of the invention, and do not permit excluding others from using the knowledge to conduct further research.

Subsidising open science – the incentive to create knowledge under open science is the recognition and status of being the first person to make a discovery. This recognition requires laying out research results in a very public way (i.e. publication). Status also accrues to scholars in relation to the number of citations to their published work. This provides an incentive for making discoveries that others will find interesting and useful for further research. The downside of open science is the cost of funding it (usually by the taxpayer) and the risk of weak incentives on researchers to ensure their work is sufficiently relevant to yield high social returns.

Public subsidies for private R&D – these usually come in the form of tax concessions or grants to firms that undertake R&D. The primary motivation for these subsidies is that they compensate firms undertaking R&D for the spillover benefits that accrue to other firms.

Direct government purchase of research – the government purchases research directly either by choosing among offers from potential research providers or through direct funding of research organisations. Sometimes the government uses this research to help it provide goods and services such as military and civil defence, environmental protection and public health services. In other cases - mainly basic research - the new knowledge is published according to the norms of open science. In still other cases, the rights to the intellectual property created are assigned to the research provider to exploit commercially.

Prizes for inventors – Governments or private benefactors have sometimes offered large prizes to the first person to come up with a solution to a particular problem or challenge. The discoverer receives the prize in exchange for the solution being made widely available. A famous example of this was the British Admiralty’s offer in 1714 of a large prize to the first solution to the problem of determining longitude - critical for accurate marine navigation. The prize stimulated much ingenious research and building of devices and was eventually awarded to John Harrison. He worked along quite different lines to the scientific orthodoxy of the day by inventing an extremely accurate ship’s clock or chronometer.


  • [7]An interesting side point is that most studies suggest that spillovers between industries are important as well as those within industries.
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