Using Economic Theory for Policy E. Maskin Institute for Advanced Study

1. Using Economic Theory for PolicyE. MaskinInstitute for Advanced Study 25th Anniversary of FEDEA Madrid November 10, 2010

2. Many economists (including me) attracted to economic theory because • besides being intellectually fascinating • thought it could make world a better place • Will argue that, economic theory has made world better place • Two distinct contributions (1) positive (2) normative

3. (1) Positive Economic Theory • economics helps us understand how particular economic institutions work - - or don’t work • take the market for navel oranges • if you’re in charge of getting navel oranges produced and allocated to consumers, want to maximize consumers’ welfare ‒ producers’ cost • How would you do this?

4. One way • Another way • set price p

5. second method is essentially competitive market mechanism efficient - - solves maximization requires transmitting a lot less information than first method one can show competitive mechanism requires less information transmission than any other efficient mechanism Hayek (1945) Hurwicz (1977) Jordan (1982) In fact, can do away with centralized price setter (unconstrained) bilateral bargaining leads to efficient outcome Gale (1987) 5

6. Thus, economic theory gives us great insight into when and how competitive markets work well: if (as in navel orange market) many agents (consumers and producers) no significant externalities then competitive markets generate efficient outcome Arrow and Debreu (1954) 6

7. Theory also shows when markets don’t work well Example - - air pollution for optimum for equilibrium: p = price of pollution reduction so, air pollution not reduced efficiently through market 7

8. Today, more interested in: (2) Normative Economic Theory how can economic theory be used to create better institutions? to formulate good policy? 8

9. 2 Examples drawn from issues I’ve worked on myself in increasing order of theoretical and empirical difficulty 9

10. Example 1 – pollution reduction argued before that competitive market cannot adequately deal with pollution But major contemporary problem ‒global warming‒ is pollution problem (greenhouse gas emissions) What to do? 10

11. several years ago, British government wanted to induce major greenhouse gas-emitting producers to reduce emissions voluntarily budget = $500,000,000 Challenge: allocate budget in way that maximizes emission reduction 11

12. More precisely, • budget B • for each firm j, j = 1, … , m • good approximation: • mechanism: • outcome : each firm j assigned

13. Transfers must satisfy subject to budget constraint individual rationality incentive compatibility 13

14. Economic theory gives us: Solution: (assuming low costs more likely than high costs) if no bids less than B, if, for some k, exactly k bids less than B/k if, for some k, more than k bids less than B/k but fewer than k + 1 less than B/(k + 1) Generalizes to different capacities for different firms 14

15. Advantages for economic analyst: government controls mechanism we (analyst) know what game is firms know what game is no extensive empirical work needed 15

16. Example 2 ‒ Software Patents Should software be patentable? policy issue still open in EU To answer question need theoretical framework that incorporates both costs and benefits of patenting need to formulate policy objective then asses parameter values empirically 16

17. Benefit: patents encourage innovation inventor cannot make discovery without incurring costs without patent, discovery can be freely imitated imitation reduces inventor’s revenue from discovery so, inventor may not even cover costs anticipating this, inventor may decide against incurring costs in first place society deprived of valuable innovation 17

18. Costs (1) patents confer monopoly power but this argument by itself doesn’t outweigh benefit can adjust patent horizon many significant innovations attributable to patents e.g., most modern drugs given huge R&D costs, need high-powered incentive schemes patents or prizes advantage of patents over prizes: don’t have to know goal in advance 18

19. (2) patents may interfere with innovation consider software computers semiconductors all highly innovative industries, but weak patent protection (at least in early history) frequent imitation Natural experiment in U.S. with software before 1985 software not protected after 1985, courts ensure enforceability but decrease in software R&D per firm similar story in Japan 19

20. What’s different about software (as compared to drugs)? innovation highly sequential rather than single big break-through each innovation is small and builds on previous innovations 20

21. Why does sequentiality make big difference? suppose I’ve made a discovery (mousetrap) and put a patent on it suppose you have idea how to build on my discovery (better mousetrap) because you’re using what I’ve discovered, my patent can block you so, then my patent reduces innovation 21

22. Not complete argument if your follow-up R&D so important then should be profitable but then why don’t I license discovery to you? could presumably capture some profit by charging license fee 22

23. Problem: what fee will I set? I am a monopolist have exclusive right to my discovery economic theory indicates that monopolist has incentive to set prices too high So, I am likely to set license fee so high that significant risk you won’t pay it so, significant risk your R&D will be blocked 23

24. So patents can interfere with follow-on innovation What about original discoveries? aren’t patents still needed to induce me to invent mousetrap in first place? Answer: not as much as in case of non-sequential innovation with sequential innovation, if I decide to incur R&D costs, raise probability of mouse trap discovery also raise probability of follow-on discoveries so potential benefit of R&D bigger if I capture just fraction of benefit without patents, then patents not so important 24

25. Thus, in industry with sequential innovation patents reduce follow-on innovation although patents still promote original innovation, not so important as in nonsequential world thus, if industry is sequential enough we may be better off without patents 25

26. This is theoretical argument Forms framework for empirical test Bessen and Hunt (2004) suggests that in U.S. software patents have been detrimental to welfare 26

27. Use of normative economics more difficult than in carbon mechanism case don’t know exact game that software inventors are playing game much less under analyst’s control many parameters uncertain - - cost of R&D, value of discovery, degree of sequentiality,... What is right policy objective? (max consumer + producer surplus?) But theory perhaps even more important in patent case there are so many factors that could be important theory enables us to focus on a few that are truly important, e.g., sequentiality Economic theory not only useful good policy would be hopeless without it 27