Innovation is at best a marginal part of the standard theory of the firm and has received only slightly more attention in modern growth theory. In the neoclassical theory of the firm, firms compete based on price, but Baumol argues that in a capitalist economy innovation rather than price is the primary competitive dimension, and less innovative firms will find their markets shrinking as they lose business to their more innovative competitors. Thus, innovation is essential to the survival of firms in a capitalist economy. (Baumol,2002).


The essential idea behind the Baumol model is that innovation is necessary and drives growth in a capitalist economy. Baumol identified innovation as the catalyst for the growth of the free market despite the failures of the free market system

To enable the existence of the growth machine in a practical free market system there are five basic elements � oligopolistic competition, routinisation, productive entrepreneurship, rule of law, and technology selling and trading; some necessary preconditions for the existence of a workable free-market economy that need to be considered.

Baumol states that Firms compete based on innovation rather than price - a main key for competition, thus making it an important tool for growth in an economy. Hence Innovation has replaced price as the main competitive instrument in main parts of the economy due to oligopolistic competition. Routinisation of these competitive activities makes them a regular and even basic component of the activities of the firm, thereby minimizing the uncertainty of the process. [Baumol. J W, 2002]

This model also focuses on the unspoken relationship between the entrepreneurs and firms who are the primary sources of innovative progress in the market and the routines of high tech research by larger organisation. Baumol sees the likelihood of these firms engaging in various forms of technology sharing and exchange, as a natural and desirable outcome of the action of profit-seeking firms operating in competitive markets, thus bringing about equilibrium between the protection of innovation and the distribution of it as well.thus enhancing growth through the symmetry between first and second movers advantage.

Baumol notes that innovation has the ability to raise newer ideas through spillovers of different types where - inappropriate spillovers benefit from innovation that are not only everywhere, but when within restrictions they contribute importantly to further technological progress, rather than being the barrier to progress-inducing investments, and desirable spillovers occur in part through cross-licensing of patents and know-how among rival firms. (F. M. SCHERER, 2002).

Baumol's model for market technology also discusses balancing the first and second mover advantages; due to profits incentives and competition among firms' new entrants are encouraged. The sales and transfer of technology is a way of balancing trade for second movers although this is risky for first movers, risky as the second mover might take over the market completely (example of BETAMAX and VHS) Innovation produces new markets. The first mover in the markets have a greater edge because they can continue innovating on an existing product or develop a new one while making money from selling technology to second movers. It is important for the first movers to continue innovating to help inspire further innovation. These continuous processes of routinisation are as a result of competition among firms, management is forced to put more into R&D to increase market shares. As a result, there is the possibility that profits from innovation under routinisation would be zero unless sunk costs generate a problem to entry.

However the routinisation of innovation and knowledge has collective effects on supply and consumption. We can also interpret the set techniques used to routinise innovation as a repertoire of actions. The structure of firms and the institutionalisation of innovation are linked with the possibility that first movers strategise routinisation of innovation and technology trading.

THE BAUMOL'S MODEL OF INNOVATION BASED GROWTH AND ITS LIMITATIONS Limitation of the Baumol model is that it emphasise the importance of routinized R&D as the primary tool for economic growth more than entrepreneurial. There are concerns that corporate planning and bureaucratized R&D really is the engine of economic growth, although it has an indisputable contribution to continual improvements in the standard of living. Baumol's argument of routinized R&D leaves one wondering if routine R&D is necessary for firms to survive, and where the innovation comes from? And how they are able to get to the market? (RANDALL G. HOLCOMBE2004)

According to Sheshinski, E. et al. (2007), the Baumol model focuses on the implicit partnership between independent entrepreneurs, who are the primary source of innovative breakthroughs in the market place and high-tech corporations with their routinised research and development activities. These shows a conflict in Baumols model of innovation drives growth, rather one can conclude from this that routine drives growth rather than innovation.)

Mowery and Rosenberg note that the process of invention has become strongly institutionalized where the institutionalization of innovation and changes in the organization of research activities have strongly contributed to economic growth, they also suggest that while innovation is market driven, there are also supplies constrained in terms of knowledge. They emphasise the importance of based and applied research, goes further to talk about incremental and systematic innovation and that both cannot work simultaneously in a firm. The firm has to choose between developing innovation or change products and processes.

However Mokryr argues that the impact of knowledge rather than innovation is the basis for growth. He states that propositional knowledge which is a general and important for social and economic growth is not driven by the market, although important it is not the main knowledge needed for growth. Rather prescriptive knowledge which is derived from techniques and prescriptive instruction is driven by the market and is the most important tool for innovation driven growth.

According to Baumol, innovation is a routines process but firms are actually influenced by routine and not innovation, but (Paul David (1997) argues that it is a random process which leads to non-ergodic process of development and generates a network effect. Paul David disagrees with Baumol saying that the reasons why firms innovate is to be the best in the market and he is a supporter for the winner takes all and believes there's no second mover he advocates for first mover. Paul David also notes that routines can affect firm in conceptualising performance and customer's perception of utility.


Baumol's ability to develop his arguments and deep insight regarding the economic system is unrivalled in its innovation and depths. His emphasises on the importance of small and large firm's contribution to innovation. He analyses the shortcomings of the growth theory, taking into consideration innovation as the key factor that drives growth.His ability to incorporate innovation into this theory creates a clear insight into the theory of the firms and the role they play in the growth model. This he has done with a good insight into the real world with reference to technology transfer among firms. (RANDALL G. HOLCOMBE, 2004)



Baumol. W J, 2002. The Free-Market Innovation Machine. Princeton University Press

Fagerberg, J. (2003) Schumpeter and the revival of evolutionary economics an appraisal of the literature. Journal of evolutionary economics Vol 13; 125-159

F. M. Scherer The Journal of Economic History, Vol. 62, No. 3 (Sep., 2002), pp. 912-913

Published by: Cambridge University Press on behalf of the Economic History Association

Gunnar Eliasson, Magnus Henrekson (August 2003 ) William J. Baumol: An Entrepreneurial Economist on the Economics of Entrepreneurship Economics: The journal of small business economics Vol. 23 NO.1 Springer Netherlands

Holcombe, R.G. The quarterly journal of Austrian economics. Vol. 7, No. 1 (spring 2004): 79-84.

Kilne, S. J, Rosenberg, N. "An overview of innovation". Reviewed by Lahdau, R. and Rosenberg, N. The positive sum strategy; Harnessing technology for economic growth. Washington D.C National Academy Press pp 275-304

Sheshinski. E, Strom. R J, Baumol. W J. (2007). Entrepreneurship, Innovation, and the Growth Mechanism of the Free-Enterprise Economies. Princeton University Press.


Baumol, W. (2002) The Free-Market Innovation Machine; Analysing the Growth Miracle of Capitalism, Princeton University Press

Mowery D.C and Rosenberg N. (2000) Paths of Innovation:Technology Change in 20th-Century America. Cambridge University Press

Mokyr,J(2002) The Gifts of Athena: Historical Origins of the Knowledge Economy, Princeton University press.

Lecture notes week 1-5 (2010) Innovation and Global competition (Dr Giuliano Maielli)

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