Arrow, K. (1962) 'Economic Welfare and the Allocation of Resources for Invention'

Question 1

What are the difficulties with achieving optimal allocation of information?

Answer 1

cost of transmitting knowledge very low → optimal allocation calls for unlimited distribution

information is an indivisible commodity (you can’t buy or sell part of it without often revealing the whole thing) → problem when it comes to optimal allocation

owners of information are monopolists → will try to extract value from the information (not good from an optimal allocation perspective)

information is non-rivalrous (once information is known by one person, it can be used by another without being depleted)

Question 2

What is Arrow’s Information Paradox?

Answer 2

The value of a given body of information for a purchaser is not known until he has the information, but then he has in effect acquired it without cost.

Question 3

Why do we expect a free enterprise economy to underinvest in invention and research?

Answer 3

We expect a free enterprise economy to underinvest in invention and research (as compared with an ideal) because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use.

Question 4

What kind of research will especially be subject to underinvestment?

Answer 4

Basic research. Becuase its riskier, harder to profit from, slower to pay off, and more likely to benefit others than the investor.

Question 5

Why has Arrow’s information paradox been argued to show the need for patent protection?

Answer 5

If inventors cannot protect their ideas, they may not have enough incentive to create them in the first place.

The information paradox creates a market failure:
- Buyers don’t want to pay for information they can’t verify.
- Sellers don’t want to reveal it unless they’re paid.
So, no efficient trade occurs, and information is underproduced.

Patents make information excludable (the inventor can safely disclose the idea without losing control of its value).

Patents encourage disclosure.
Without protection, inventors might keep innovations secret (trade secrets).
Patents require public disclosure of the invention in exchange for legal protection.

Patents incentives innovation.
Patents allow temporary monopoly profits, giving firms a financial reason to invest in risky R&D.
Helps overcome Arrow’s concern that markets underinvest in invention.