Modeling the Effects of Free Innovation on Social Welfare

Social welfare functions are used in welfare economics to provide a measure of the material welfare of society, with economic variables as inputs. A social welfare function can be designed to express many social goals, ranging from population life expectancies to income distributions. Much of the literature on innovation and social welfare evaluates the effects of economic phenomena and policies on social welfare from the perspective of total income of a society without regard to how that income is distributed. The model presented in Gambardella, Raasch, and von Hippel (2016) takes that viewpoint.

On the face of it, free innovation should increase social welfare. It involves decisions by individuals to divert part of their discretionary unpaid time, generally assumed in economics to be devoted to consumption, to activities that produce value for the innovators themselves, and often produce value for additional peer and commercial adopters too (Henkel and von Hippel 2004).

As markets move from a traditional producer-only situation to a situation including free innovators, the modeling of Gambardella, Raasch, and von Hippel (2016) finds that both producers' profits and social welfare always increase if firms adopt a strategy of investing in complementing free innovation activity instead of competing with it. In contrast, if producers elect to compete with free innovators' designs, both producer profits and social welfare are likely to suffer.

In other words, and as I noted at the start of this chapter, the modeling and theory building my colleagues and I have done concludes that the most profitable and welfare-enhancing situation in the economy involves a division of innovation-related labor between free innovators working within the free innovation paradigm and producers working within the producer paradigm. The optimal division of labor, however, will not be arrived at without policy interventions. As the number of free innovators in markets increases steadily as a result of the technological trends described in chapter 3, our model shows that producers generally switch from a producer-only innovation mode to a mode utilizing free innovation "too late” from the perspective of overall social welfare. The reason is that overall welfare includes benefits that accrue to free innovators and increase social welfare, but that are not taken into account in private producers' calculations of returns.

Producers assess their private returns to investments in supporting free innovation by considering the value they are likely to derive from increased creation of commercially valuable free designs by free innovators. But investments by producers to support free innovation also support the creation of designs that have personal and social value but do not have commercial value. In addition, producers' investments to support free innovation induce other types of self-reward valued by free innovators but not by producers—for example, the learning and enjoyment that free innovators gain from participating in free innovation development. For these reasons, a level of investment supporting free innovation that is higher than the level that is optimal for producers' profits always enhances social welfare.

To bring these added sources of welfare into welfare calculations, my colleagues and I argue that calculations of social welfare should include a "tinkering surplus” component. Social welfare is conventionally calculated as profits (PS) plus a consumer surplus (CS). We suggest adding tinkering surplus (TS) as a third component to social welfare, consisting of all the net benefits from self-rewards that free innovators gain from developing their innovations. How significant is the omission of the tinkering surplus in conventional welfare calculations? Given the importance of self-rewards to free innovators documented earlier, the omission can be substantial.

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