Critically discuss the incentives to innovate in the Arrow model.

Arrow (1962) formalized a model explaining technical change as a function of learning derived from the accumulation of experiences in production. Radical innovation – one that reduces marginal costs a lot. This outcome is well represented in the following simplified version of the Arrow’s model that, in turn is based on the following assumptions: 1. Knowledge underlying innovation is a public good (non-rival and not excludable) 2. Radical process innovation, that reduces marginal costs 3. Only one firm wins the race to innovate and gets to apply for a patent 4. The uncertainty in the innovation process is limited. We can imagine that the innovation is available to the firm that is willing to pay more for the patent right 5. The model compares the incentives under two scenarios: monopoly vs. perfect competition There is an incentive (TI) to innovate if: TI = π post−innovation − π pre−innovation This monopolistic firm decides to innovate according to TI, that is the positive difference between the post innovation profit (rectangle P ′mehc′) and the pre-innovation profit (rectangle Pmbgc). By introducing a radical process innovation, the monopolistic firm not only sets the post innovation price (P ′m) lower than the previous one (Pm), but P ′m is also lower than the previous constant marginal cost (c) Incentive to innovate in a perfectly competitive market: Many competitive firms, but only one can win the race and gets the patent. Now, TI is the positive difference between the post innovation profit (rectangle P ′mehc′) and zero, the TI of competitive firm is larger than TI of monopolistic firm. This because no profits were accruing to the competitive firms before introducing innovation. After introducing innovation, the competitive firm becomes a monopolistic firm. Incentive to innovate of the social planner: If the government supports innovation a competitive market is guaranteed, competitive firms sell goods at lower prices, no monopoly emerges and the social welfare increases. The social planner has the biggest TI, but the government may not have the resources to finance all innovations, hence reducing the overall amount of innovation. By endowing discoverers with property rights over the fruits of their efforts, patents affect the incentive to innovate and are likely to increase the flow of innovations. But by giving the patentee exclusive rights on the exploitation of a unique economic good that is still non-rival in consumption, a patent creates a monopoly situation