The Economic Justifications for Government Support of Technological Advancement

The following is culled from a paper I wrote (footnotes omitted):

The development and deployment of technologies for combating climate change should not be left to the private sector alone, even if governments were to take the essential step of pricing the externality of greenhouse gas emissions. Economics demonstrates that implementing a carbon tax or an emissions permit trading system is the most cost-effective method of achieving the indispensable goal of inducing private actors to factor the social cost of emissions into their decisions. Instituting such a policy is the single most significant step that governments can take to mitigate climate change. But it is a necessary step, not a sufficient one. For economics also demonstrates that the technology sector is plagued by its own set of market failures, which entail that emissions pricing alone will not give firms the optimal incentive to develop and deploy technologies for producing cleaner energy. In turn, the marginal cost of achieving a given unit of emissions reduction will be higher than is ideal. The public sector must intervene in order to ensure the efficient level of technological investment. As Adam B. Jaffe, Richard G. Newell, and Robert N. Stavins aptly recapitulate, we should

view technological change relative to the environment as occurring at the nexus of two distinct and important market failures: pollution represents a negative externality, and new technology generates positive externalities. Hence, in the absence of public policy, new technology for pollution reduction is, from an analytical perspective, doubly underprovided by markets.

The importance of factoring technological change into an analysis of the cost of abating greenhouse gas emissions should not be underestimated. As explained previously, the development of new technologies, the commercialization of viable innovations, and the employment of readily available advancements make up the world’s toolkit for enabling the benefits of ravenous energy consumption not to come at the cost of our planet and our future. The aforementioned authors note that “the single largest source of difference among modelers’ predictions of the cost of climate policy is often differences in assumptions about the future rate and direction of technological change.” Good technology policy should render these assumptions more favorable, thereby lowering the expected cost of emissions abatement.

The first subsection below explicates the failures in the R&D market that justify public support. The second subsection deals specifically with the related, but distinct, set of market failures that impede the private deployment and diffusion of clean energy technology.

Failures in the Market for Research and Development

The primary failure in the R&D market is that technological innovation creates positive externalities in the form of “knowledge spillovers,” so the market produces too little innovation. R&D generates knowledge that has the characteristics of a public good: one individual’s consumption of the good does not reduce the amount of the good available for consumption by others, and no one can effectively be excluded from using the good. Because firms cannot capture all of the benefits of R&D, they have socially suboptimal incentives to engage in it. Some studies of commercial innovation have concluded that, on average, originators only appropriate about half of the gains from R&D. Hence the value of government intervention in the market.

A second basis for intervention is that most of the benefits of climate change mitigation are so long-term as to be outside the planning horizons of private funding instruments. Private firms are obligated to focus on private costs, benefits, and discount rates in order to satisfy their shareholders. This can result in insufficient emphasis on returns, however valuable, that will not materialize until far into the future, when many shareholders have reached the Keynesian long-run. Moreover, these issues are compounded by the considerable uncertainty – and perceived uncertainty – about climate change, which renders long-term returns impossible to precisely quantify. Several studies have found that the “implicit discount rates” that firms use when making decisions about investment in long-term climate change mitigation are frequently much higher than market interest rates due to various market barriers and failures, such as inadequate information. Firms are generally suboptimally aware of energy conservation opportunities and often lack the expertise necessary to implement them – another instance of the underprovision of the public good of knowledge.

A final impediment to R&D funding is the asymmetry of information between innovators and potential investors about the prospects of new technologies. Innovators tend to be in a better position to assess the potential of their work, so favorable assessments are usually met with skepticism and demands for greater risk premiums. This intensifies the knowledge spillover problem because subsequent producers of a successful technology will be able to obtain financing on better terms. All of the above difficulties are surely magnified in today’s credit-constrained market, preventing even more of the up-front funding that R&D requires.

One means of addressing the mismatch of private and social returns is the enforcement of intellectual property rights. For example, patents grant innovators temporary monopolies on their innovations, which they can use to charge monopoly prices and thereby possibly recoup their share of the full social value of their innovations. In the absence of such protections, creators who market new technologies will likely soon face competition from others who take advantage of the technologies’ public availability and produce their own versions. Although the original developer may have a head start in marketing her development and may be able to command a greater market share due to her status as originator, these market-based incentives are tenuous, ephemeral, and uncertain. For instance, it is equally likely in theory that an imitator will be able to produce the good or service more cheaply or at a higher quality. It is also likely that consumers will anticipate the entrance of such competitors and therefore refrain from consumption during the innovator’s initial marketing. Thus economic analysis supports the use of intellectual property rights to ensure that inventors will be adequately driven by the profit motive. Patents are certainly a key component of any pro-innovation policy scheme.

However, intellectual property rights are neither a sufficient nor always desirable response to the failures of the R&D market. To begin with, much of the value of a given R&D project may consist of knowledge that is, for good reason, outside the scope of the intellectual property rights regime. The Stern Review offers the example of “tacit knowledge,” which is vague and does not satisfy the requirements of patentability. Another concern is that due to the inherent uncertainty of legal regulation, patents and the like do not always preclude all of the competition that prevents innovators from reaping their full rewards. Additionally, the prospect of monopoly pricing may not be a sufficient incentive to encourage risky, large-scale basic research. Analogously, pharmaceutical companies are known not to develop treatments for diseases that affect a sufficiently small segment of the population. As for the undesirability of robust intellectual property rights protection in the R&D context, one downside is that it can hinder or even cripple progress by preventing firms from building on each other’s successes and learning from each other’s failures. The early stages of innovation are often characterized by a high degree of uncertainty due to the lack of a well-defined path to progress. When there are multiple R&D avenues worth exploring, it pays to have multiple firms collaborating. Industry-wide collaboration is also vital for achieving big breakthroughs in basic science, such as those necessary to commercialize hydrogen fuel cell automobiles, which a single company is ill-equipped to deliver. This cooperation is unlikely to materialize if individual firms are given the incentive to keep their efforts under wraps while hoping to free-ride on the work of others.

In light of these concerns, many economists advocate direct government subsidization of technological innovation, especially at the level of R&D. This funding can take several forms, such as government-performed research, government contracts, grants, tax breaks, technology prizes, and incentives for students to study science and engineering. Of course, the government and private organizations can tailor these options to meet their needs in a given situation. Economists also promote government efforts to remedy the excessive myopia and uncertainty with which private decisions about long-term investment in climate change mitigation are fraught. These programs take a variety of forms, including educational workshops and training programs for professionals, advertising, product labeling, and energy audits of manufacturing plants.

Failures in the Market for Deployment and Diffusion

Although economists more strongly and consistently back government support for R&D, many also call for government responses to imperfections in the markets for technology deployment and diffusion. Successful R&D does not guarantee that the resulting innovation will immediately be deployed; market forces also govern firms’ decisions about technological implementation.

Economists have identified that firms in an industry may face a collective action problem when deciding whether to adopt new technologies that exhibit “dynamic increasing returns.” This phenomenon exists when the value of a technology to one user depends on how many other users have adopted the technology; in other words, the more users there are, the better off they will be. There are three types of positive externalities that generate dynamic increasing returns: “learning-by-using,” “learning-by-doing,” and “network externalities.” As in the R&D context, these externalities may give rise to a collective action problem because each firm can partake of the public fruits produced by the first adopters of a new technology; in turn, each firm is disinclined to be at the vanguard of technological adoption, and the deployment of worthwhile technology is unproductively delayed. Learning-by-using refers to the fact that the initial users of an innovation generate valuable public information about it, such as its existence, characteristics, and performance. Learning-by-doing, the “supply-side counterpart,” refers to the fact that production costs fall as firms gain experience, which they cannot fully keep to themselves. For one, a product itself usually provides insight into its production. Lastly, network externalities exist when the value of an innovation increases as others adopt a compatible product. Telephone and computer networks are obvious examples.

In addition to these externalities, certain characteristics of the power generation sector further deter and postpone the deployment of technologies that are expensive and commercially unproven. The sector is subject to a high degree of regulation and tends to be quite risk averse. Second, technologies that do not easily fit into existing infrastructures such as power grids and gas stations are unlikely to enter the market until demand rises and/or costs fall enough for the industry to act en masse. For example, national grids are usually designed with central, as opposed to distributed, power plants in mind, and CCS will require the construction of new pipelines. Third, there are market distortions such as the aforementioned fossil fuel subsidies, which make it even harder for new technologies to compete. Finally, energy markets tend not to be particularly competitive. The oil-market is a well-known oligopoly, dominated by a multinational cartel, and electricity generation is a natural monopoly, in that a single firm can provide power at the lowest social cost due to economies of scale.

These problems can be mitigated or eliminated if there exists a niche market that is willing to pay a high price for early access to an innovation, as was the case with the first mobile phones. Niche markets can enable the initial producer of an advanced technology to profit despite subsequently facing competition from other firms that have the benefit of following in its footsteps and taking advantage of the externalities described above. Otherwise, originators must hope that they can eventually turn a profit – for instance by initially selling at a loss and then maintaining a dominant market share as costs fall and the market expands, perhaps by virtue of customer goodwill. Neither of these scenarios is likely in the energy market due to the homogenous nature of the end product (e.g., electricity), which makes it difficult for innovators to distinguish themselves. Although niche markets for carbon-free electricity exist, they are too small to make the costly implementation of advanced technology worthwhile. Consequently, established technologies can become locked-in, progressing only incrementally. At worst, the Stern Review notes that “energy generation technologies can fall into a ‘valley of death’, where despite a concept being shown to work and have long-term profit potential they fail to find a market.”

There are several desirable public policy responses that can be tailored to different problems in different markets. As in the R&D context, various types of subsidies and information programs can counteract market failures. The government can also use energy efficiency standards, such as emissions quotas, to force firms in an industry to implement environmentally friendly technologies.