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Chapter 2
Innovation
Chapter Overview
Innovation is the transformation of something new, such as an invention, into a practical application that
creates value for human beings. Innovations can either reduce the cost of producing what we already have
or provide new goods and services (or improve their quality). Innovations raise the wealth of both
innovators and consumers. This does not mean that everyone benefits from every innovation—indeed,
innovations often increase the competitive pressure felt by some firms, and thus make them worse off. For
this reason, innovations are sometimes met by efforts to prevent or limit their introduction.
Descriptive Analysis
A simple depiction of the wealth-enhancing effects of innovation is shown in Figure 2-1, on the next
page. Panel (a) illustrates the impact of an innovation that increases the use-value of a good to consumers.
The pre-innovation demand and supply curves are given by D0 and S0. The initial equilibrium is at point
A, with equilibrium price and quantity shown by (P0, Q0). The innovation—perhaps superior performance
or longevity of the good—raises the marginal value to consumers by an amount equal to the vertical
distance from point A to point V. As shown, this increase in marginal value raises the demand for the
good to D1. Consumers bid the equilibrium price up to P1>P0 and consume the new equilibrium quantity
of Q1>Q0.
Because the equilibrium price of the good rises, we can be confident that the innovators—the firms
selling the new, improved good—gain from their actions. These gains can be thought of as having two
elements. First, firms receive a higher price per unit (P1) on all of the Q0 units that they had previously
been willing to sell at P0. This increment to profit is simply (P1 – P0)Q0. The higher price also induces
firms to sell (Q1 – Q0) additional units, on which new profits are also earned. With a linear supply curve,
for example, this increment to profits is given by 0.5(Q1 – Q0)(P1 – P0).
Despite the higher price of the good, consumers also benefit from the innovation. This is because the
marginal value of the good rises by more than the price of the good rises: the increase in marginal value,
shown by the distance from A to V, exceeds the price rise, P1 – P0. As with suppliers, we can think of the
gain to consumers consisting of two parts. First, they enjoy more consumer surplus on the Q0 units they
were consuming prior to the innovation. Second, the rise in quality induces buyers to purchase more, and
they enjoy new gains from trade on these (Q1 – Q0) units.
Panel (b) shows the effect of a different type of innovation, one that reduces the marginal (and thus
average and total) cost of producing the good. Again we have pre-innovation demand and supply curves
D0 and S0, with the initial equilibrium at point A. Prior to the innovation, price and quantity are shown by
P0 and Q0. The innovation causes marginal costs to fall by an amount equal to the vertical distance
between A and C. This cost reduction causes the industry supply curve to shift to S1. Competition among
suppliers hoping to take advantage of their lower costs drives equilibrium price down to P1, which in turn
induces consumers to raise purchases to Q1, the new equilibrium quantity.
The gain to consumers is immediately apparent, and is brought about by the fall in the equilibrium price
of the good. Consumers enjoy higher gains from trade (consumer surplus) of (P0 – P1) on each of the
original Q0 units consumed, plus they enjoy added consumer surplus on the extra units (Q1 – Q0) they buy
at the new, lower price. Suppliers also gain from the innovation, despite the fall in equilibrium price. This
occurs because the per-unit cost reduction (the vertical distance from A to C) exceeds the price reduction
(the vertical distance from P0 to P1). Again, we can think of these new profits (or producer surplus)
conceptually as stemming from two sources: the firms earn more on the Q0 units they had been willing to
sell before at the old price and costs, and they also profit from selling more units.
Even though both types of innovation raise the total wealth of society, some people in society may be
made worse off because of a specific innovation. The superior products resulting from the innovations
shown in panel (a), and the lower prices accompanying those highlighted in panel (b) will both draw
customers away from other firms, lowering the wealth of their owners. This may induce the non-
innovating, competing firms to enlist the government in suppressing the innovations. The ride-sharing
services Uber and Lyft, for example, create wealth by raising output quality and lowering production
costs. But their competition also lowers the wealth of conventional taxi companies, whose owners have
had success many places in getting governments to limit or even prohibit Uber and Lyft. Although such
restrictions on competition have been presented as “consumer protection,” in fact they reduce the wealth
of consumers.
Sometimes an innovation produces great economic benefits, but does so in a way that the casual observer
might not recognize. This is often the case for innovation in the health industry. Consider, for example,
drugs to treat hepatitis C, a viral infection of the liver that, in 70 to 85 percent of the people infected, will
produce long-term chronic health problems, often death, if the disease is not successfully treated.
Approximately 3.2 million people in the United States are infected with hepatitis C. Until recently, the
only “treatment” for the disease rarely worked and generally produced severe adverse side effects. People
with the chronic version of hepatitis C thus faced a life of great uncertainty, and could expect mounting
medical bills as the disease progressed. For about 15,000 of these people each year, the culmination was a
painful, premature death. In 2013, however, a new drug was introduced that cures about 90 percent of the
patients who take it, generally with no significant side effects. The problem, in the eyes of some people, is
that the pharmaceutical company that created the drug set the price of a full 12-week course of treatment
at approximately $84,000.
For the 3.2 million people with hepatitis C, the price of a health-preserving and life-saving treatment was
reduced from infinity to $84,000. Yet many people have argued that the company who developed the drug
should not be allowed to charge this much for it—that such a sum is “unreasonably high.” Given that the
drug exists, it is true that $84,000 is far in excess of the manufacturing costs of producing the drug. But it
was only the prospect of being able to charge a price far above manufacturing costs that induced the
company to undertake the highly risky R&D that led to the drug. Limiting the price the firm can charge
will, in the short run, save money in treating the people who have hepatitis C. But it will also serve as a
lesson to this company and all others in all industries, that the rewards from R&D are lower than they had
previously believed. This will reduce firms’ R&D investment on a wide scale, and thus produce lower
rates of innovation and lower economic growth and economic wellbeing. (For more details on the
consequences of limiting the prices firms can charge for their products, see Chapter 11, “Bankrupt
Landlords, from Sea to Shining Sea.”)
Chapter Answers
1. Innovation has made the world today far more prosperous than 100 years ago, and helped people
live much longer lives. Both seem good reasons to prefer today rather than then. Continuing
innovation in the future is likely to make the citizens of the 22nd century even richer, healthier,
and longer-lived.
2. Most inventions yield no commercially viable products—although there are probably no readily
available data that would tell us whether it takes exactly a dozen to generate a dime’s worth of
profits.
3. All research and development is a venture into the unknown. After the fact some R&D will yield
profitable innovations, while most will not. But before the fact no one knows which of the R&D
efforts will turn out to be profitable and which will not. Because it is not possible to know ahead
of time which R&D will succeed, the decision to invest in R&D can only be made by comparing
all of the R&D costs will all of the net revenue thereby generated.
4. When the growth rate is 0.9 percent per year it takes approximately 78 years (about a human life
span) for income to double. Over that same time span, if the growth rate is 2.1 percent per year,
income will rise by a factor of five.
5. After-tax income in the high tax state will be $83,000 per year, but it will be $90,000 in the low-
tax state. Ceteris paribus, the low tax state is the preferred location for the business.
MARYLAND.
Nov. 27th, 1860. Gov. Hicks declined to call a special session of the
Legislature, in response to a request for such convening from
Thomas G. Pratt, Sprigg Harwood, J. S. Franklin, N. H. Green,
Llewellyn Boyle, and J. Pinkney.
December 19th. Gov. Hicks replied to A. H. Handy, Commissioner
from Mississippi, declining to accept the programme of Secession.
20th. Wm. H. Collins, Esq., of Baltimore, issued an address to the
people, in favor of the Union, and in March a second address.
31st. The “Clipper” denied the existence of an organization in
Maryland to prevent the inauguration of President Lincoln.
A. H. Handy of Mississippi addressed citizens of Baltimore in favor
of disunion.
January 3d, 1861. Henry Winter Davis issued an address in favor
of the Union.
3d. Numerous Union meetings in various part of the State. Gov.
Hicks issued an address to the people against secession.
11th. John C. Legrand in a letter to Hon. Reverdy Johnson replied
to the Union speech of the latter.
14th. James Carroll, former Democratic candidate for Governor,
announced his desire to go with the seceding States.
16th. Wm. A. Spencer, in a letter to Walter S. Cox, Esq., declared
against the right of Secession but for a Convention.
16. Marshal Kane, in a letter to Mayor Berrett, denied that any
organization exists to prevent the inauguration of President Lincoln,
and said that the President elect would need no armed escort in
passing through or sojourning within the limits of Baltimore and
Maryland.
24th. Coleman Yellott declared for a Convention.
30th. Messrs. John B. Brooke, President of the Senate, and E. G.
Kilbourn, Speaker of the House of Delegates, asked the Governor to
convene the Legislature in response to public meetings. Senator
Kennedy published his opinion that Maryland must go with Virginia.
February 18th. State Conference Convention held, and insisted
upon a meeting of the Legislature. At a meeting in Howard Co.,
which Speaker E. G. Kilbourn addressed, a resolution was adopted
that “immediate steps ought to be taken for the establishment of a
Southern Confederacy, by consultation and co-operation with such
other Southern and Slave States as may be ready therefor.”
April 21st. Gov. Hicks wrote to Gen. Butler, advising that he do not
land his troops at Annapolis. Butler replied that he intended to land
there and march thence to Washington. Gov. Hicks protested against
this and also against his having taken forcible possession of the
Annapolis and Elkridge railroad.
24th. A special election of ten delegates to the Legislature took
place at Baltimore. The total vote cast in all the wards was 9,249. The
total vote cast at the Presidential election in November, 1860, was
30,148.
26th. Legislature reassembled at Frederick, Annapolis being
occupied by Union troops.
29th. Gov. Hicks sent a message to the Legislature communicating
to them the correspondence between himself and Gen. Butler and
the Secretary of War relative to the landing of troops at Annapolis.
The House of Delegates voted against Secession, 53 to 13. Senate
unanimously.
May 2d. The Committee on Federal Relations, “in view of the
seizure of the railroads by the General Government and the erection
of fortifications,” presented resolutions appointing Commissioners to
the President to ascertain whether any becoming arrangements with
the General Government are practicable, for the maintenance of the
peace and honor of the State and the security of its inhabitants. The
report was adopted, and Otho Scott, Robt. M. McLane, and Wm. J.
Ross were appointed such Commissioners.
Mr. Yellott in the Senate introduced a bill to appoint a Board of
Public Safety. The powers given to the Board included the
expenditure of the two millions of dollars proposed by Mr. Brune for
the defence of the State, and the entire control of the military,
including the removal and appointment of commissioned officers. It
was ordered to a second reading by a vote of 14 to 8. The Board was
to consist of Ezekiel F. Chambers, Enoch Louis Lowe, John V. L.
MacMahon, Thomas G. Pratt, Walter Mitchell, and Thomas Winans.
Gov. Hicks was made ex-officio a member of the Board. This
measure was strongly pressed by the Disunionists for a long time,
but they were finally compelled to give way, and the bill never
passed.
6th. The Commissioners reported the result of their interview with
the President, and expressed the opinion that some modification of
the course of the General Government towards Maryland ought to be
expected.
10th. The House of Delegates passed a series of resolutions
reported by the Committee on Federal Relations by a vote of 43 to 12.
The resolutions declare that Maryland protests against the war, and
does earnestly beseech and implore the President of the United
States to make peace with the “Confederate” States; also, that “the
State of Maryland desires the peaceful and immediate recognition of
the independence of the Confederate States.” Those who voted in the
negative are Messrs. Medders, Lawson, Keene, Routzahn, Naill,
Wilson of Harford, Bayless, McCoy, Fiery, Stake, McCleary, and
Gorsuch.
13th. Both Houses adopted a resolution providing for a committee
of eight members, (four from each House) to visit the President of
the United States and the President of the Southern Confederacy.
The committee to visit President Davis were instructed to convey the
assurance that Maryland sympathizes with the Confederate States,
and that the people of Maryland are enlisted with their whole hearts
on the side of reconciliation and peace.
June 11th. Messrs. McKaig, Yellott and Harding, Commissioners to
visit President Davis, presented their report; accompanying which is
a letter from Jefferson Davis, expressing his gratification to hear that
the State of Maryland was in sympathy with themselves, was enlisted
on the side of peace and reconciliation, and avowing his perfect
willingness for a cessation of hostilities, and a readiness to receive
any proposition for peace from the United States Government.
20th. The House of Delegates, and June 22d, the Senate adopted
resolutions unqualifiedly protesting against the arrest of Ross
Winans and sundry other citizens of Maryland, as an “oppressive and
tyrannical assertion and exercise of military jurisdiction within the
limits of Maryland, over the persons and property of her citizens, by
the Government of the United States.”
MISSOURI.
South Carolina.
To Alabama, A. P. Calhoun.
To Georgia, James L. Orr, Ex-M. C.
To Florida, L. W. Spratt.
To Mississippi, M. L. Bonham, Ex-M. C.
To Louisiana, J. L. Manning.
To Arkansas, A. C. Spain.
To Texas, J. B. Kershaw.
To Virginia, John S. Preston.
Alabama.
Georgia.
Mississippi.
South Carolina.
Alabama.
W. P. Chilton.
Stephen F. Hale.
David P. Lewis.
Thomas Fearn.
Richard W. Walker.
Robert H. Smith.
Colin J. McRae.
John Gill Shorter.
J. L. M. Curry, Ex-M. C.
Florida.
Mississippi.
W. S. Wilson.
Wiley P. Harris, Ex-M. C.
James T. Harrison.
Walter Brooke, Ex-U. S. Senator.
William S. Barry, Ex-M. C.
A. M. Clayton.
Georgia.
Louisiana.
Duncan F. Kenner.
Charles M. Conrad, Ex-U. S. Senator.
Henry Marshall.
John Perkins, jr.
G. E. Sparrow.
E. De Clouet.
Texas.