the economic efficiency of information producing activities

The Economic Efficiency of Information Producing Activities*

1. Introduction Arrow’s economic analysis of the production of knowledge has

a t its centre a resource allocation model under uncertaixy in which ‘. . . equilibrium has precisely the same Pareto-optimality properties as competitive equilibrium under certainty’ [l; p. 6111. The model developed by Arrow [2] , and generalized by Debreu [ 51 , considers the efficient resource allocation of any commodity over tirie in conditions in which the economic environment is subject to uncertainties. The extension of this analysis t o the production of knowledge, by Arrow [ 11, obviously involves exploring the implications of treating information as a commodity. Having discussed the efficient allocation of resources to invention under ideal conditions, Arrow proceeds to argue that, in the case where the real economic system is a free enterprise one, embracing decentralized decision-making units, underinvestment in invention and research is inevitable.

Arrow has been criticized by Demsetz [S ] on the grounds that he exaggerates the significance of the discrepancies between present institutional arrangements and a postulated ideal n0rm.l 1.n this note, attention is focused on the relevance of the Arrow-Debmu model to resource allocation problems involving information-prol~ucing economic agents.

Arrow, in showing that information cannot be traded in perfectly competitive markets, concludes that the resource allocation mechanism in the Arrow-Debreu model is a t fault. However, it is argued that it is not surprising that resources will not be allocated to the production of this commo&ty since it is defined as one that does nct appear in the commodity space of the Arrow-Debreu model except by definition. Furthermore, Arrow, in envisaging legally imposed property rights as an institutional device to enable a market to develop in .;he products of information-producing facilities, has not exhausted the ways in

*This note is a revision of the theoretical content of a paper entitled ‘Eco- nomic Analysis and the Governmental Sponsorship of Industrial Research and Development’ read before Section 24 (Economics), 43rd Congress of the Aus- tralian and New Zealand Association for the Advancement of Science, Brisbane, May 1971.

‘Demsetz also discusses Arrow’s conclusion about the role oi monopoly in the production of information,

57s

576 THE ECONONIC RECORD DEC.

which economic agents could be envisaged as adjusting to the peculiar ‘technological characteristics of the imention process and the nature of the market fo r knowledge’ [l; p. 6091.

A counter-example is used to demonstrate that Arrow’s analysis is incomplete. Consequently, the claim that theory demonstrates that there must be a considerable underinvestment in information production must be treated with considerable caution.

2. Uncertainty and Pareto Optirnality A formal statement of Arrow’s treatment of Pareto optimal

resource allocation under uncertainty, applicable to any commodity, may be found in Arrow [2] and, in a generalized treatment, in Debreu [ 5 ; pp. 98-1021. It is sufficient to consider the differences between resource allocation under certainty and uncertainty in an economy where a standardized variety of wheat is the sole commodity. Under certainty, the resource allocation problem in the ‘present’ is suscep- tible to a textbook analysis. The results can be generalized to take into account such things as (a ) different varieties of wheat, (b) different locations and, even, (c) different dates of delivery t o the consumer. In this analysis, it is assumed that producers and consumers know with certainty what kind of wheat will be arailable in what quantities on what particular dates.

Essentially Arrow’s contribution consists in pointing out that if the production of wheat is likely to vary in a n uncertain manner because of, say, the unpredictable pattern of the veather, a Pareto- optimum can still be obtained, provided producers and consumers can trade in options to buy wheat. An option represents a right to obtain a specified quantity of wheat a t a specified location on a specified date, depending on the weather having been, between the present and the specified date, precisely as described on the option document. The producer delivers his wheat to the consumer presenting the right option, i t being assumed that i t was known in the ‘present’ exactly what each of a finite range of weather patterns would be and exactly what effect each weather pattern would have on production.

Under such a system i t would be possible f o r a consumer to purchase, say, one unit of a specified variety of Theat at a specified location on a specified date by purchasing an option to buy one unit for each of the possible weather patterns which would have affected the output of the relevant wheat producing areas. There is an assumption, of course, that a separate market exists to deal in all possible options to purchase wheat. Furthermore, it is not surprising that the assumptions in the model have the effect that consumers would be willing to pay more for a more likely, than for a less likely, weather pattern associated with a particular option. But the producer receives a payment for each possible weather pattern so that the market mechanism acts so as to make his reFard independent of the weather pattern which actually occurs. Consequently, the Pareto-optimality

1972 EFFICIENCY OF LYFORMATION PRODUCTION 577

properties of equilibrium are preserved because the market system allows all the requisite trades to take place.

One important assumption made in the Arrow-Debreu model, which must always be kept in mind, is that every market for an option is ‘perfect’.

3. Information and Pareto Opt imul i ty Clearly, if the above analysis is to be applicable, knowledge must

be treated as a commodity. As an indication of how a market might develop in information, consider the following example taken from Arrow.

Suppose, ‘an observation has been made whose outcome, if known would affect anyone’s estimates of the probabilities of the different states of nature’ [l; p. 6141. When this happens, ‘information will frequently have an economic value, in the sense that anyone possessing the information can make greater profits than would otherwise be the case’ [l; p. 6141. The resource allocation problem is to make effective use of this information, and to reward appropriately the producers of this commodity, since it has economic value, so that the output of the information is at an optimal level.

Arrow believes that it is not possible to do this in a Pareto-optimal manner in a decentralized decision-making market econcmy. This is because, assuming that the cost of transmission of a piece of information is nominal, the optimality conditions require the ixif ormation’s unrestricted distribution without a charge being levied. Clearly, no market resource allocation is needed for such a commodity. Further- more, since commodities are only produced to satisfy the demand for a commodity at a market price no information will ke produced. Consequently, there will be no invention in circumstances where the existence of a market for the invented commodity is necessary to induce it.

Arrow recognizes that i t can be argued that this problem could be overcome within the framework of a market economy by making suitable institutional arrangements to give the inventor property rights in his invention. Arrow argues that such institutio;aal arrangements that might be made will only be partly effective in establishing a market in the invention. There are just too many ways in which it is possible to make ‘free’ use of information,

The analysis has, so far, only considered the supply of information. What about the demand fo r this commodity? Arrow argues that i t is certainly subject to indivisibilities. In obtaining information about production possibilities, for example, it may be found that the use of the information does not depend on the rate of production. However, a more fundamental problem is the difficulty of attempting to sell information as a commodity when it cannot be evaluated by the purchaser until he knows what i t is. Of course, once again, institutional arrangements regarding the use of the information may be relevant.

573 THE ECONOMIC RECORD DEC *

4. I n f o r m t i o n as a Commodity Par t of the strength of Arrow’s argument is that i t appears t o

reconcile, in a single account, both the fear that the technological capabilities of society are not being utilized to their fullest extent and the obvious presence of inventive activity in our midst. However, for purposes of analysis, i t is useful to put t o one side Arrow’s recognition of the legal protection of property rights in information and to consider what information-producing activities would be con- sistent with their absence.

Although an Arrow-Debreu world without property rights in information might be thought to be a singularly unenlightened place, i t is interesting to note the role that information plays in an Arrow- Debreu model in which i t is assumed to be a commodity,

Five roles f o r information can be distinguished : (a ) there is the information contained in the limited technological knowledge of those economic agents who are producers and whose production plans are constrained by this technological knowledge ; ( b ) there is the information contained in the knowledge of the prices which rule in each of the option markets for commodities whose production is feasible, given the limited technological knowledge of the producer ; (c) there is the information which is a commodity and which must appear in the commodity space2 of the Arrow-Debreu model; (d ) there is the information which is a commodity but which has a zero price. This is free information. This commodity must also appear in the commodity space of the Arrow-Debreu model ; ( e ) there is the information which is necessary t o make sense of the following sentence that appears in Debreu : ‘the certainty assumption implies that he knows now what input-output combinations will be possible in the future (although he may not know now the details of the technical processes which will make them possible) ’ [ 5 : p. 381.

It will be noticed that, in assuming information is to be treated as a commodity, a new role has been created for it. As Arrow himself points out, information which is already k n o w has no value. Con- sequently, it cannot be assumed that the resource allocator already knows about something when he will only purchase it if he does not know about it. Therefore, information is not a commodity except by definition. I f i t were not defined t o be a commodity by Arrow himself, the economist could be pardoned by arguing that the kind of information Arrow has in mind cannot be analysed in terms of the Arrow- Debreu model because this model demands in the present all the relevant information about the present and the future. Sew information would involve a change in expectations and, consequently, some additional assumptions as to how economic agents will react t o the possibility that information can change. And i t would appear reason-

2 See Debreu [ s], pp. 28-36.

19 72 EFFICIENCY OF INFORMATION PRODUCTION 579

able for such an economist to argue that Pareto optimality would then break down because economic agentg cannot cope with the task of computing optimal strategiesV8 However, this is not the argument used by Arrow.

5. Imf omtiom- pro awing Economic Agents In the previous section, markets in property rights in information

were not discussed. Obviously, in such markets the criticisms made above of Arrow’s position would not apply. Or, in other words, the way to avoid these criticisms is by specifying suitable institutional arrangements which allow information to be treated as a commodity in 8 manner comparable to the way other things are treated as commodities.* The institutional arrangements chosen by Arrow are ones that are not considered by him to weaken his case. It mity be asked whether it is possible to envisage alternative institutional amangements which are more likely to allow resources to be allocated to information- producing activities in a Pareto-optimal manner. An obvious starting point for this line of enquiry is to consider whether info:rmation can be treated as a commodity in a more satisfactory manner.

What is needed is some treatment of information as a. commodity so it can appear in the commodity space of the model. without it being distinguished from other commodities. For example, information can be provided as a service (information is clearly imlike those objects Debreu treats as a good). Among the services tliscussed by Debreu is the example of human labour. It is interesting to consider what Debreu says of this service:

‘Its description is that of the task performed; thus one has the labor of a coal miner, of a truck driver, of a member of some categories of teachers, of engineers, of draftsmen, of executives, etc. (all including any further specification necessary for a complete description). When one adds date and location one has again a well-defined commodity. The quantity of a specified type of labor is expressed by the time worked (a real number)’ [ 5 ; pp. 30-311. So information can be treated as a commodity if the commodity

is human labour which provides information a the tasks that it per- forms. In itself, this definition does not necessarily change Arrow’s argument for, if someone provides valuable information, the value of the information may so outweigh the costs incurred that it is possible to speak of them, as Arrow does, as being ‘nominal’. However, the use of this definition does have four advantages. These me that: (a) it makes it quite clear that 8 distinction must be dritwn between

a See Radner 191, p. 35 who implies that the model is at fault whereas Arrow argues that it is the mechanism represented by the model which is imperfect.

4The important contribution made by Arrow is to stress that economists cannot assume that information is a commodity in the conventional sense of that term.

580 THE ECONOMIC RECORD DEC.

the limited technological information of economic agents and its use to decide what additional information might be purchased as an input to the productive process ; (b) it allows consideration of the circumstances under which information production and transmission could be a profitable activity for a n economic agent. While Demsetz’s objection is valid, that ‘modern analysis has yet to describe efficiency in a world where indivisibilities are present and knowledge is costless to produce’ [ 6 ; p. 191, considerable progress can be made by examining the case where indivisibilities are not present and the production process is not costless ; (c) it is readily seen that the possibility that a major invention can occur at some unforeseeable time in the future may raise the problem of the efficient distribution, from a social point of view, of this information without the issue of the private allocation of resources to research and development being raised j (d) it focuses attention on the fact that information is not homo- geneous. The kind of additional information needed f o r a more efficient allocation of resources may not necessarily be the kind of information whose production is most discouraged in a decentralized decision making, free enterprise, economy.

Having found a definition of information which allows it to be treated as a commodity, it is desirable t o see what effect the use of a more specific definition has on those problems Arrow identified as arising when information is treated as a commodity.

The value of this change in the definition of information which, it may be noted in passing, makes the production of information bear a closer resemblance to the ordinary use of the term ‘invention’, can be seen by an examination of the problems that Arrow identifies as arising when information is treated as a commodity.

Arrow assumes that the cost of transmission of information is nominal. But, it is interesting to examine an alternative assumption under which there exist producers who are information producing and transmitting agents. Obviously, information will not be produced and transmitted unless this activity is profitable. If this human labour were designated as ‘consultants’ rather than ‘inventors’ then the mental block that some students have to visualizing information as a service provided by an information-producing agent, rather than an abstract free good, the output of inventors, may be overcome. Now what the marginal cost is, from a social as well as a private point of view, of a consultant conveying new ideas to a producer becomes a question of fact. However, if the new idea is unforeseeable in the ‘present’, the relevance of the Arrow-Debreu model may be doubted on two grounds. Not only is it not concerned with specific changes in expectations, but also it cannot cope with ‘time and ~ h a n c e ’ . ~

5 See Radner [9] and Stigum [ll]. Presumably, if the new idea is foreseeable as becoming available in the future then it is information in the fifth sense distinguished above.

1972 EFFICIENCY OF INFORMATION PRODUCTION 581

Consequently, even if it is accepted that information about some inventions should be free, it does not necessarily follow that efficient resource allocation requires free access to the results of all inventive activity, o r that no inventive activity occurs if not fbanced from the public purse. In particular, where it is important that the right information be available at the right time and at the right place, the market mechanism may have a role to play because information cannot be ‘unbundled’ by just contemplating it.

There is clearly room for some fascinating empirical. studies of particular firms and industries, to determine the extent to which managements are capable of deriving benefits from information-producing services without the existence of some consultant-like human agent who demonstrates to firms how they can apply the new knowledge in their particular circumstances?

The next problem is that of the inappropriability of i:nformation. The use of information reveals it and consequently its value is reduced or destroyed. In neither approach is there any incentive for an economic agent to produce this kind of information, but in the counter-example the absence of legal protection does not prevent the sale of an information-providing service.

Turning to the demand for information, Arrow suggests, as an example of the problem of indivisibilities, that some information use need not depend on the rate of production. In the approach suggested, it is possible to envisage changes in the demand for idormation because the content of the information provided by the iinformation- providing and transmitting economic agent may be regarded as being dependent on the expected demand for the commodity in whose production it is being used. What is being bought by the producer is not any piece of information, but one that is being mercliandised as being appropriate to his needs. Consequently, the market can signal a willingness to buy more information, for what is important is not the information which might potentially be used but the information firms are prepared to use.

The presence of an intermediary between the potentjal inventor and the potential user allows estimates to be made of the intended adoption of some new product or technique.

A further comment that might be made is that it is$ important to stress that what is being valued by market prices is the price for the provision of a service. It might conceivably be, in Demsetz’s terminology,‘ a public but not a collective good. This could occur if transmission, but not production costs, of an information service are low. However, as pointed out by Demsetz [7 ; pp. 296-29(3] this still does not imply that the service should be provided at a nominal charge.

No mention will be found of any comment made by Arrow on the effect of uncertainty about the value of the information provided.

6The paper by Simon and Golembo [lo] is of interest in this regard. 7 See Dernsetz 171.

582 THE ECONOMIC RECORD DEC ,

Obviously, in the suggested approach, what producers have to evaluate are the uncertainties associated with the provision of a service, which is a commodity, and the discussion of Section 2 is now relevant.

6. Cmctclusio.n Arrow’s analysis may be appropriate in cases where there is an

expectation that new information should be produced, and i t does not eventuateus

Where information is being produced, Arrow can point to the existence of property rights in information which can ‘explain’ information production without nullifying Arrow’s argument that information production is inefficient in a free enterprise, decentralized decision-making economy.

It has been shown, by means of counter-example, that it is plausible to envisage information production occurring in the Arrow- Debreu world for reasons other than the existence of property rights. The counter-example also suggests that information production need not involve inefficiencies in resource allocation.

The objection to Arrow’s analysis is basically methodological. Even if the counter-example given is not acceptable, the validity of Arrow’s analysis depends on the impossibility of institutional arrangements being postulated which allow the efficient allocation of resources to information-producing activities. Given the widespread nature of these activitiese the likelihood of such arrangements being postulated is surely not fanciful. Under these circumstances Arrow’s general solution to the resource allocation problem for information-producing activities-nationalization-appears t o be rash, particularly given the possibility that the state may intervene in the economy in a more selective manner.

COLIN A ~ S L ~ B I E university of Newcastle

REFERENCES [ l ] Arrow, K. J., ‘Economic Welfare and the Allocation of Resources for In-

vention’, in National Bureau of Economic Research, The Rate and Directiolt o f Inventive Acfivity (Princeton University Press, Princeton, 1962), pp.

[2] Arrow, K. J., ‘The Role of Securities in the Optimal Allocation of Risk- bearing’, Review of Economic Studies, Vol. XXXI, 1964, pp. 91-96 ( a trans- lation of a papef first published in French in 1952).

[3] Arrow, K. J., Classificatory Notes on the Production and Transmission of Technolonical Knowledrre’. American Economic R m ‘ m . Pabers and Pro-

609-625.

.Holland, Amsterdam, 1971 8 For a fuller discussion by Arrow of the economic implications of informa-

tion producing activities from both a macroeconomic and a microeconomic point of view, see Arrow [ 3, 41.

counted for 29% of the gross national product of the United States. 9 Machlup suggests that in 1958 ‘total knowledge-production’ [8; p. 3621 ac-

1972 EFFICIESCY OF I N F O R U A T I O B PRODUCTIOS 583

[ 5 ] Debreu, G., Thpory of Valiie (John U‘iley and Sons Inc., ,Sew Y ork, 1959). [6] Demsetz, H., Information and Efficiency : Another Viewpoirt’, Journal of

[7] Demsetz, H., ‘The Private Production of Public Goods’, Journal o j Lazw

[8] Lfachlup, F., T h e Production and Distribution of Knowledge in t h e L‘nited

[9] Radner, R., ‘Competitive Equilibrium under Uncertainty‘, Econometrka, Vol.

Law a d Economics, Vol. XI I , April 1969, pp. 1-22.

and Economics, Vol. XIII, October 1970, pp. 293-396.

States (Princeton University Press, Princeton, 1962).

36, January 1968, pp. 31-58. [ lo] Simon, J. L. and Golembo, L., ‘The Spread of a Cost-free Business Innova-

tion’, Jotrral o/ Business, Vol. 40, October 1967, pp, 385-388. [ 111 Stigum, B. P., ‘Competitive Equilibria under Uncertainty’, Q w ~ f e r l y Journal

of Economics, Vol. LXXXIII , Kovember 1969, pp. 533-561.

the economic efficiency of information producing activities

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