Ideas are non-rival and non-excludable in nature. Meaning multiple people, firms or countries can have the same idea at the same time and nothing can stop them from having said idea, commonly called public goods. You would think that ideas bringing perfect information into the markets would also enable perfect competition to exist, but this doesn’t necessarily hold. Generating new ideas, both good and bad, costs money. It costs a lot of money actually, specifically fixed costs.
If a firm has high fixed costs from research and development (R&D), the idea sector, it must have a way to pay those costs back. Innovation is expensive. Because of high fixed costs there needs to be incentives to recover said costs by charging above marginal cost, or at the monopoly price. Patent laws were created to incentivize people to innovate by granting periods of monopolization and by punishing those who break the laws, in today’s society the punishment is usually a monetary fee paid back to the patent holding firm.
Lets look at two different countries. In Country A and Country B, there are two different policies in regards to idea formation. In Country A, there are no patent laws. A company can spend an enormous amount of money on R&D and come up with a new drug, toy, computer technology, process, etc., while another firm spends no money and reap all the benefits of selling this new idea. In economics we describe this process as the Free Rider Problem. Now in Country B they try to curb the free riding with patent laws, to incentivize idea creation. Which country would you rather run a company in? Wouldn’t Country A cost a heck of a lot more than Country B in relation to R&D? Wouldn’t you just continue producing the same good without innovating in Country A?
In the example, firms would prefer Country B to Country A because the patent laws grants a temporary monopoly in the market so firms in Country B could charge the monopoly price to recover their high fixed costs and to make economic profits for the new idea. A market will never stay in perfect competition. The high fixed costs of R&D require patents laws to help the firm pay back the costs at the front end. These patents create imperfections in markets, but facilitate new idea formation leading to innovation. Both the Romer and Schumpeterian models house this theory, but differentiate in their microfoundations.
With both models the output is a function of new idea formation. A company spends labor on both goods and idea production. The Romer model describes that new ideas simply add onto old ideas. The Schumpeterian on the other hand has an element of creative destruction, in which new ideas destroy old ideas. Think of classic records and streaming music on Spotify. For example, the graph below shows how new technology, like smartphones and tablets, made the news, classifieds and other newspaper elements more easily accessible to the public and cheaper for the production companies to provide.
The two models also differentiate what the new ideas bring to life and how the ideas are formed. The Romer model describes new ideas as an increase in the variety of goods and reveals that ideas are continuously evolving, adding to the current stock of ideas. While the Schumpeterian model indicates that new ideas as an increase in the quality of goods and that there is an uncertainty or probability that new ideas will be framed through R&D.