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What a Bargain!

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In a recent NBER working paper [2] – “Schumpeterian Profits in the American Economy: Theory and Measurement” – Yale economist William Nordhaus [3] estimates that innovators capture a mere 2.2% of the total “surplus” from innovation. (The total surplus of innovation is, roughly speaking, the total value to society of innovation above the cost of producing innovations.) Nordhaus’s data are from the post-WWII period.

The smallness of this figure is astounding. If it is anywhere close to being an accurate estimate, the implication is that “society” pays a paltry $2.20 for every $100 worth of welfare it enjoys from innovating activities.

Why do innovators work so cheaply? One possible reason is alluded to by Nordhaus himself: excess optimism. Nordhaus suggests that over-optimism might explain the late 1990s tech-market equity bubble. The social gains from innovation were in fact very large, but the ability of investors to capture more than a small sliver of these gains – rather than see these gains flow to consumers in the form of lower prices and improved products – proved undoable.

Another possible explanation for why innovators work so cheaply is that the prospects, few as they might be, for capturing gargantuan shares of the gains from innovation are sufficiently attractive that even rational, well-informed entrepreneurs and investors perform and fund innovating activities, each hoping that he or she will be among the tiny but inordinately lucky handful of entrepreneurs and investors who personally do capture a much-much-greater-than-normal share of the value of their innovative endeavors.

Whatever the reason, Nordhaus’s empirical evidence supports (at least my) casual observation that innovative economic activity yields benefits that are both enormous and widespread.