Many large firms contain research and development (R&D) divisions. Employees in these divisions engage in product development and process development.Product development consists of developing new products and improving a firm’s existing products. Process development consists of finding improvements in a firm’s operations and methods of manufacture to reduce the costs of production.
An example of product development is the development and testing of a new pharmaceutical compound to treat cancer. An example of process development is the way in which transportation firms now use global positioning systems (GPSs) to better manage the movements of their trucks. In either case, firms invest today in the hope of gains in the future from lower production costs and better products.
Knowledge of this kind is also created by independent research laboratories, universities, think tanks, and other such institutions. In many cases, governments subsidize these institutions: policymakers actively intervene to encourage the production of new knowledge. Governments get involved because new knowledge can benefit lots of different firms in an economy. Think of how the invention of electric power, the internal combustion engine, the microchip, or the Internet benefits almost every firm in the economy today.
Economists say that basic knowledge is a nonrival. A good is nonrival if one person’s consumption of that good does not prevent others from also consuming it. A good is rival if one person’s consumption prevents others from also consuming it. The fact that one marketing manager is using economic theory to set a profit-maximizing price doesn’t prevent another manager in a different firm from using the same piece of knowledge. (Contrast this with, say, a can of Coca-Cola: if one person drinks it, no one else can drink it.) Knowledge is also often nonexcludable. A nonexcludable good is one for which it is impossible to selectively deny access. In other words, it is not possible to let some people consume a good while preventing others from consuming it. An excludable good is one to which we can selectively allow or deny access. Once a piece of knowledge is out in the world, it is difficult to prevent others from obtaining access to it. Nobody has patents on basic economic principles of price setting.
Together, these two properties of knowledge mean that a discoverer or inventor of new knowledge may not get all, or even most, of the benefits of that knowledge. As a result, there is insufficient incentive for individuals and firms to try to create new knowledge.
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