To what extent do market failures result in a similar optimal allocation of resources to the innovation process? What might EU Policy do to correct such failures?

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To what extent do market failures result in a similar optimal allocation of resources to the innovation process? What might EU Policy do to correct such failures?

Innovation has a crucial impact on the standards of living in particular economy.  It is generally agreed that research and innovation are the main sources of growth and job creation in market economies.  i.e. output is increased through greater acquisition of knowledge.  Subsequently, 2 things matter for economic growth: savings and the state of the productive knowledge (i.e. shows how productivity the extra capital will be used).  The production function diagram below can illustrate this

Where labour productivity per worker experiences diminishing marginal returns

This diagram shows how economic growth can be realised by accumulation of capital and/or higher levels of knowledge.  It should be noted that productivity growth is the difference between the growth of inputs and the growth of outputs and that technological progress is measured as residual-so that any problems with measuring inputs or outputs, will be transferred onto measuring technological progress.

There are 2 movements on the diagram: a to b – due to the accumulation of capital and b to c – due to the growth of productivity or technical progress.  The difficulty with this is that if knowledge had not changed, the movement from a to b will not have been experienced. The only reason capital has been accumulated is due to the increase in technical progress.  Generally speaking technological progress generates new wealth in two ways: either through innovative process which help to increase the productivity of labour and capital and thus enable production levels to increase and/or to save available resources, or through innovative products which lead to the creation of new markets and industries and give a boost to investment and create jobs, Hence the principal source of growth is innovation.

A general consensus states a positive incidence of technological progress on growth, competitiveness and employment.  Enormous amounts of money are spent on innovation and studies reveal that the economic return on innovation is very high in relative terms.  Reviewing the diagram on returns to innovation below can see this.

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Graph2

The demand curve indicates the marginal valuations of this particular product and it is assumed that a single monopoly supplier produces the goods with constant marginal costs – c and sets prices above marginal costs at P.  The private rate of return is B as the firm exploits its product and receives a private rate of return extended over time against the cost of innovation.  The social rate of return is larger as it is the sum of the private return and consumer surplus i.e. (A+D).  Better measures can be seen ...

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