The main idea behind Baumols model is that Innovation is the motivating force behind the growth miracle of capitalism. In the neoclassical theory of the firm, firms compete based on price, but William Baumol argues that in a Capitalist economy innovation rather than price is the main competitive dimension and less innovative firms will find their markets shrinking as they lose business to their more innovative competitors. Thus, innovation is essential to the survival of firms in a capitalist economy.
Baumol argues that innovation has replaced price as the most important factor that lies behind economic growth. He suggests that even though it has been recognized that important innovations stem from small firms, individuals or entrepreneurs, the bulk of innovative activity however is carried out by large oligopolistic firms. Baumol’s argument supports Schumpeter’s distinction between entrepreneurs led and routinized innovation. Schumpeter held that technological competition was the form of competition for all types of firms but Baumol argues that it is mainly large oligopolistic firms that engage in this type of competition and this explains why in his analysis Baumol focuses mainly on oligopolistic firms.
Explaining the Baumol Model of Innovation
While acknowledging price competition, Baumol stresses that large corporations use innovation as the most important weapon for competition. He further explains that firms do not intend to risk too much innovation as it is expensive and can be made obsolete by rival companies. Therefore, organisations have to divide the differences through the sale of technology licenses and participation in technology sharing compact that pay huge dividend to the economy as a whole which makes innovation a routine feature of economic life.
Baumol suggests that there are five important pre-conditions for the existence of the free market economy which are oligopolistic competition this means competition among large firms where innovation is the prime weapon, routinization of innovation activities which makes them an ordinary component of the activities of a firm thereby reducing the uncertainty of the process. Productive entrepreneurship which is incentives for entrepreneurs to devote themselves to productive innovation rather than innovative rent seeking, the rule of law includes carrying out contracts and protecting contracts from illogical expropriation that is, property rights, royalties and copyright and technology selling and trading which is simply the way firms pursue opportunities for profitable dissemination of innovation.
These pre-conditions are the features of the free market economy. In other economies, they might exist in weaker forms and sometimes not exist at all. Baumol argues that these features are important for explaining the growth accomplishments of the free market.
Criticisms against the Baumol Model of Innovation
Baumol focuses on the partnership between independent entrepreneurs who are the primary source of innovative breakthroughs in the marketplace and high tech corporations with their routinized research and development activities whose primary accomplishment has been the steady improvement of the innovative products and processes contributed by independent entrepreneurs and the vast increase in the capacity of those products and processes. The emphasis in this analysis is on the critical role of the entrepreneur.
Oligopolistic Competition refers to competition among large firms where innovation is the prime weapon, ensuring continued innovative activities and their growth. In this situation a few large firms dominate a particular market. However, it might be argued that a theory of innovation based growth needs to take into account the different types of firms that exist, their mutual interaction and the selection processes allowing some firms to grow while others may be forced out of business.
Innovation is one of the mechanisms of economic growth. It can be explained by repertoires and actions, the profit earning mechanism drives firms toward routinization of the innovation process, and it in turn tends to limit the resulting profits. Thus, routinization is one major means by which firms reduce the risks faced in their innovation rivalry. A considerable degree of routinization is now standard in a wide variety of firms including telecommunications, information technology and pharmaceuticals.
According to Baumol refers to a firm’s intentional pursuit of opportunities for profitable spreading of innovations and leasing of the right to use them that is, equilibrium between protection and diffusion and also equilibrium between first and second mover advantages. First movers have two possibilities, sell new products and the technology to develop new products, for second movers there is no incentive to steal as he is buying technology from first movers. This is very important as it reduces the problem of spillovers which tend to impede the introduction of innovations whose social benefits unlike private returns exceed their cost. However, the first mover advantages matter a lot but second mover is not as important as everyone is locked-in to first movers even on the onset of new technologies and this is not consistent with the Baumol model.
Baumol also looks at the realities of the individual players in capitalism most importantly, the interplay between the small independent entrepreneur innovators and the large established corporations.
Another aspect of Baumol’s model is how risk and uncertainty is being treated. Uncertainty is an important aspect of innovation in the sense that in most cases you never know what the outcome will be, according to Baumol, innovation that shows real uncertainty is designed for small firms as large oligopolistic firms, he argues, engage in more routine type innovation, which is more predictable but he does not provide enough evidence to support this.
Also, Baumol sees innovation as demand driven to minimize cost of production and create products to meet the market demand with the aim of maximizing profit, however innovation is demand driven, driven by routines but also supply constrained that is, by the supply of knowledge and one has to invest in prepositional knowledge as they are connected together which could lead to highly routinized process.
Baumol also looks at innovation from micro level and how it is driven by the fact that actors can compete in the market.
Baumol also asserts that if all benefits were captured by innovators, then the labor force would be permanently condemned to extremely low nutritional and educational levels. However, the argument overlooks the fact that with given resource endowments, innovation raises the amount of social product available for distribution.