Fortunately, we don't get this pessimistic result because the two kinds of increasing returns go together. This means that even though one firm may control a large fraction of the market at any point in time, there is another way for new firms to compete. Instead of trying to enter the market by providing exactly the same product as the incumbents at a lower price, they can enter and compete by selling something that is new and better. This is precisely what Microsoft and Intel did when they displaced I.B.M. as the dominant force in the computer market. It is what firms like Netscape, Sun and Oracle are trying to do now by leveraging the emerging power of the Internet. Economists call this monopolistic competition. It's a form of competition between different firms, each of which sells a different kind of product and can behave like a monopolist at least temporarily.
Of course, it takes various kinds of institutional infrastructure to make this system work. For example, the Government has to grant property rights over intangible assets like ideas.
S&B: The property rights you are referring to are patents, copyrights and so on?
Paul Romer: Yes, and these differ from the property rights we are familiar with for physical objects. You can give dispersed ownership to something like timber or ore. Many different people can own different pieces of the same kind of asset, so they can all compete to supply ore. But if you consider, for example, a pharmaceutical product, you see that once the Government gives a firm a patent on a new drug, this firm becomes a monopolist with regard to that piece of knowledge, that recipe for how to make that drug. We give this company a legal right to keep everyone else from using its knowledge, and this means that the company can gain the dominant position in the market. So it is the combination of low replication costs to the producer and the protection of intellectual property rights that creates the monopoly position.
S&B: This means that competition tends to take place via the introduction of new goods rather than by competing on price in existing goods?
Paul Romer: Yes, that is right. It is a very different vision of how competition works and why markets are so successful in generating high standards of living. You see, the traditional intellectual justification for laissez-faire comes from dealing with a hypothetical world filled only with scarce objects. In effect, you're just trying to figure out which mine should produce how much copper and how much total copper should be produced. In such a world, the classical notion of perfect competition is feasible and it works well. Competing firms will end up charging the right price for copper in a precise sense. The market price will determine the total amount of copper that should be produced. It will also determine how much of the total each mine will produce. Classical economists were able to show that under competition, these production and allocation decisions are efficient.
In this kind of world, it is important for policymakers and the Government to step in and break up any monopoly or cartel. By keeping the cartels at bay, the price will adjust to the efficient level and the right quantities will be produced and sold.
Now let's go to this new world, where the key challenge is to produce and distribute knowledge or ideas. The first thing to notice is that you lose the classical notion of the right price. For example, with the concept of a vaccine, the best thing to do might be to give any firm the right to use this concept for free and let everybody in the world use it to make serums so that people in general can benefit. To do this, you want the price for using the concept of a vaccine to be zero after it has been discovered. Thus, for example, we could have granted a perpetual patent on the basic concept of a vaccine to Edward Jenner, who discovered the concept in the 1700's. In fact, he and his heirs have no intellectual property rights over this idea. They collect no income when researchers and doctors all over the world use vaccines and the concept of immunity to protect us from disease. After the fact, this is efficient.