Sunday, November 6, 2011

Rival and Excludable Goods

Talking of Nobel Prizewinners in Economics, one shoo-in for a future gong is Paul Romer, who has written some of the most influential work on economic growth in recent years. A reference in the Brynjolffson and McAfee book reminded me that I'd never read his original papers, although of course I'm familiar with the ideas. For all I complain about academic economics, some of it is extremely useful.

And one of the most important ideas for understanding economic change is a clearer understanding of rival goods and excludable goods. A rival good is " a good whose consumption by one consumer prevents simultaneous consumption by other consumers." (wikipedia). Most goods for sale in the store are rival goods. If I buy a packet of packet of fettucine, you can't have the same packet as well.

But some goods are non-rival, especially many kinds of intangible goods.

As for excludable goods, " a good or service is said to be excludable when it is possible to prevent people who have not paid for it from having access to it, and non-excludable when it is not possible to do so". (wikipedia again).

The music industry has, gradually and very unwllingly, been moving from an excludable model of paying for songs to coping with illegal copying and a non-excludable model. Bands increasingly give their music away, or tolerate copying, and make their money through live performances and concerts and t-shirts which are excludable.

Many of the key developments in the economy can be understood as a matter of how we should deal with nonrival, partially excludable goods.

As Romer says in the AER last year discussing the progress of growth theory:

..the defining characteristic of an idea, [is] that it is a pure nonrival good. A given idea is not scarce in the same way that land or capital or other objects are scarce; instead, an idea can be used by any number of people simultaneously without congestion or depletion.

In fact, the more people use a nonrival good, the more useful it is. There are increasing returns to scale.

No matter how it is communicated and reused, nonrivalry by itself creates strong incentives for economic integration among the largest possible group of people. As we will argue in the next section, this is the best candidate explanation for ... the relentless pressure for expansion in the extent of the market.

The existence of nonrival goods can cause problems for our usual view of markets and efficiency.

recall that the increasing returns to scale that is implied by nonrivalry leads to the failure of Adam Smith’s famous invisible hand result. The instiutions of complete property rights and perfect competition that work so well in a world consisting solely of rival goods no longer deliver the optimal allocation of resources in a world containing ideas. Efficiency in use dictates price equal to marginal cost. But with increasing returns, there is insufficient output to pay each input its marginal product; in general, price must exceed marginal cost somewhere to provide the incentive for profit maximizing private firms to create new ideas. This tension is at the heart of the problem: a single price cannot simultaneously allocate goods to their most efficient uses and provide the appropriate incentives for innovation.

An important unresolved policy question is therefore the optimal design of institutions that support the production and distribution of nonrival ideas.

(my bold). I think this is very important indeed and, naturally, could not agree more.

Romer also says we are far off having a clear idea of what such institutions ought to be.

In practice, most observers seem to agree that some complicated mix of secrecy, intellectual property rights that convey partial excludability, public subsidies through the institutions of science, and private voluntary provision is more efficient than any corner solution like that prescribed for rival goods. We are, however, very far from results we could derive from first principles to guide decisions about which types of goods are best served by which institutional arrangement.

The key thing, for me, is that as the economy evolves the relative balance between different kinds of goods are changing. The more value comes from ideas, arts, knowledge and other intangibles, the more we are in uncharted territory for understanding how to run the economy.

Most of these new sources of value are only imperfectly excludable, if at all.

Less and less of what we want falls into the category of rival, excludable goods like Rolex watches or apartments on Central Park West, where market transactions are such an efficient, effective way to allocate resources. And many more kinds of good which could be made excludable, such as gmail, can be delivered at such low marginal cost it makes more sense to give them away free and pay for them by ancillary activities, such as advertising.

And other huge areas of the economy are abstract and intangible, such as most financial products. Pricing depends less on supply and demand than attributes such as risk, real interest rates and correlations.

Less and less of the economy is the familiar marketplace where we hand over cash for a specific physical thing.

And that's why we have problems. We haven't evolved the institutions to cope with that change. The incentives to handle non-traditional goods are missing or poorly developed.

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