S&B: That's the classical, pre-breakup AT&T-Bell Labs model.
Paul Romer: Yes, but you also saw it at I.B.M. and at G.M. and on smaller scales in many firms. A number of firms mimicked the institutions and economic policies of government when they realized that knowledge-creation and discovery was central to their growth.
S&B: What came next?
Paul Romer: The firms found that these institutions did not work so well, so now they are trying to come up with modified institutional arrangements. They are recognizing that the simple solution that recreates the Government's command-and-control and tax-and-subsidy mechanisms is not the perfect solution. What they are finding is that while there are a billion haystacks in which there will be some very valuable needles, it is an enormously expensive proposition to go about looking underneath every one. So what they are asking themselves is, how do you allocate the resources that you devote to research most effectively? They are realizing that they cannot just give scientists lots of money and let them follow their curiosity. If they do, this form of tax-and-subsidy system runs the risk of dissipating efforts by looking in too many different directions that don't necessarily lead to the highest returns for shareholders. One way to think about the problem here is that a tax-and-subsidy system does not have the built-in checks on wasteful activities that are present in a market system.
As a result, firms are beginning to create market-like mechanisms that impose market tests on things like R.&D. departments. In some instances, this goes all the way to the extreme of the profit-center model. In these instances, they have set up R.&D. units as profit centers and they charge different divisions for any of the results they produce that other divisions use.
S&B: Does that work?
Paul Romer: Well, it gets back to one of the problems with knowledge, which is, if you charge high prices for knowledge, you don't end up with the efficient distribution of that knowledge.
Let me provide you with an anecdote. Someone at a company I know told me that he had taken over the market research division. The company used to be operated on the tax-and-subsidy model. The corporation used to give the marketing division lots of money and it went out and worked on anything that it wanted to. That system meant that the department was not really working on the right problems. So this manager took the market research budget and allocated it to all the different business units and told the units that they could buy whatever they wanted from the researchers. This of course made the market research folks focus more on the actual marketing problems that the different divisions were facing.
But then he ran into a problem. One division would pay the market researchers to work on problem X. Another division in the corporation would then come in and want the group to do a study on a very similar problem. It was inefficient for the market researchers to go out and redo the study, but the first division had property rights over the existing study. The market researchers could not just give it to the second division without getting permission from the first, and complicated negotiations would sometimes ensue over what the second division should pay the first. This sometimes led to restrictions on flows of information that would have helped other divisions, and this is clearly bad from the point of view of shareholders.
The lesson is that as soon as you start to price knowledge, you get into awkward situations where your knowledge is not being as widely used as it could be. This is just a fact of life.