The Free Market Does Not Encourage Innovation

Not Even In Theory

2025-06-11

The oft-repeated mantra, "The Free Market Encourages Innovation," is a powerful meme. It's wielded to justify free market reforms and dismiss anything perceived as counter to laissez-faire ideals. It's a cliché, a truism.

But there's a problem, it's wrong.

Of course there are plenty of progressive liberal critiques of this idea. Many argue that while the free market might encourage innovation "in theory," it fails in practice, pointing to trends like "enshittification", predatory monetization, dark patterns, and anti-competitive rent-seeking as evidence of existing market failure. Or others can point to the real historical role of the state in driving innovation, as detailed in works like The Entrepreneurial State by Mariana Mazzucato.

Not to mention the decline in private R&D investment in recent years, or that universities, either state funded or essentially feudal hold-overs, are the sources for many significant innovations and base technologies.

Or how evidence seems to show that if anything, extrinsic or material motivators actually decrease creativity and out of the box thinking necessary for truly groundbreaking innovation, compared to intrinsic personal and cooperative motivations.

But I will point out that these critiques ignore an even bigger elephant in the room; the free market fails to encourage innovation even according to hallowed basic economic theory.

Now, in summary, there are two distinct dynamics at play here:

First, ideal markets do encourage the spread and proliferation of innovation. If someone is doing something better than you, you have an obvious incentive to follow their example and copy them, lest you fall behind in the market. This is good for everyone, people "defecting" by copying those working smarter and more efficiently increase the overall productivity and rationality of the economy. Competition and undercutting in a market keeps prices close to cost, and keeps unnecessary costs down.

But secondly, markets discourage investment into the development of new innovations. If you sink a whole bunch of value into developing a new technique, technology, or piece of media, all your competitors can simply copy you as per above! This actually puts you behind, as you spent the money but gain no long-term edge. Even if the innovation benefits society as a whole, the individual has little incentive to sacrifice their own value and position for that greater service. A classic collective action problem, leading to underinvestment in a public good.

Of course departing from an ideal perfect market, Monopolies, can invest in innovation and capture a significant portion of the value created, as seen historically with companies like Bell and IBM. Likewise firms can also recoup investments to the extent that markets are imperfect and innovations aren't easily replicated.

Hence the common solution to this problem is intellectual property (IP) law, which has become so ingrained that we often see it as natural. IP essentially takes innovation which would otherwise be a public good, and turns into a "club" good via state granted artificial monopoly. However, it, as well as well any anti-competitive mechanism or structure which allows recouping invested value is an incomplete and problematic solution.

First, IP law ultimately relies on the threat of state force to prevent the copying of information and ideas, this alone should make it deeply unpalatable. Learning from others and improving operations makes society overall richer not damaged, unlike traditional property "theft". Yes someone "cutting in on your turf" can be costly, obviously, but that is competition. The alternative notion could be extended to argue that any form of competition or undercutting is theft, leading us back to feudal and mercantilist arrangements we've largely abandoned for good reason.

Secondly, fundamentally IP laws only, and can only, encourage investment into innovation to the extent they inhibit competition, the spread of ideas, and allow monopolistic pricing and artificial rent appropriations. This is not an unfortunate side effect which can be ameliorated, this is core to their very method of operation. Plenty of gross excesses of any existing IP system can be shaved off or patched, but this fundamental trade off will always remain, degrading a markets strong in advantage in propagating innovations.

Many propose weakening IP laws as as a progressive reform, but this is short sighted, as any extent you decrease the strength of IP laws without any other solution "kills the golden goose" of long term incentives to invest in R&D for short term gains. There's no clear "optimal" point between strong and weak IP laws that avoids this tradeoff. Arguments for any level of IP protection (other than "none") could just as easily be used to advocate for stronger IP laws. Within this framework, there's no compelling reason to move away from our current system other than vague discomfort with the bed we made to lie in.

In early capitalism, these issues may have been less pronounced. Low-hanging fruit abounded, and the primary task was propagating basic technologies and techniques. Though early patent struggles and Edison's research complex definitely gave a preview of what was to come. Today, advances face diminishing returns and arguably require far more concerted effort and investment. These contradictions are even more clear with information technology, with near-zero marginal costs for reproducing software and digital media.

But there is an alternative. If innovations and public domain technologies are public goods, why not fund them publicly, as we do with other public goods? Imagine the absurdity if we privatized and provisioned roads or national defense as club goods enforced by artificial monopoly!

Public services are entirely viable, despite the criticisms of public choice pessimists. Yes, a technocrat planning road placement may not face direct market pressures, and history (e.g., urban planning disasters) shows that bad decisions can occur. Yet, you don't have to look around much to see plenty of examples of egregious failures in markets and private firms. Theory and expertise exist to guide public investment, sometimes even surpassing the local optima that even ideal market pressures would settle on. The main complaints about public services often stem from underinvestment, not inherent inefficiency.

Some would argue IP has a strong theoretical advantage over public investment due to direct market feedback and pressures. IP laws attempt to "marketize" the evaluation of innovations' social value, more socially useful innovations should garner higher monopolistic rents, ideally directing private investment toward socially beneficial outcomes. However, this is flawed, something like a patents value is significantly influenced by the availability of alternatives and it's ability to actually be monetized, which has nothing to do with with it's overall social utility. Socially useless IP will have a hard time appropriating any economic rents, but there is no guarantee that socially useful innovations will be profitable as IP, or that IP will in general have private value equivalent to it's social value.

The argument is not that IP can not spur innovation, it does, but it only does so at the monumental cost of limiting the spread of innovation. Likewise it does not even necessarily encourage the most socially useful innovation for strong theoretical reasons expanded above.

A counter argument ultimately needs to explain "why is innovation different?" in regards to how we go about encouraging provisioning of public goods, and the response can not just be "the market encourages innovation" because that is assuming the conclusion, and we already pointed out that isn't the case, otherwise we wouldn't need IP law in the first place!

There is no room for moderation, even limited or limiting IP is still theoretically incoherent. The real ideal "hybrid", which is what is essentially proposed, is letting public funding fund the development of innovation as a public good, which solves the collective action problem, and letting competitive firms in a market do what it does best in propagating that innovation.

Of course this opens the question of how such a system for the public funding of innovations, tech, even products and media, should be actually organized. While I think a traditional public bureau would not be catastrophic, I believe there are are better options which I will elaborate in a future article.