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Knowledge plays an increasingly important role in shaping the dynamics of an economy. A static Paretian welfare economics is therefore inadequate, and needs to be supplemented by a dynamic (Schumpeterian) welfare theory. A dynamic welfare economics acknowledges the role of knowledge and communication. As knowledge develops cumulatively in a social environment, knowledge may not be readily diffused or exchanged. Different costs of communication need to be considered, each affecting the creation of new knowledge. Recent developments in Intellectual Property Right (IPR) law are evaluated to determine the extent to which they affect communication costs and thus future economic welfare.

In recent years, it has come to be acknowledged that development of new knowledge is an important source of dynamics for an economy. Knowledge is, however, a very much heterogeneous entity and thus difficult to come to grips with – using the metaphor of capital to do so may, for instance, be criticized (Dolfsma, 2001). Knowledge has distinct features that are worth discussing in light of this article. To paraphrase Isaac Newton, knowledge is developed by people who could see further because they stand on the shoulders of giants. This, of course, is a well-established observation about the cumulative nature of development of knowledge, but at the same time was a derisive remark against Newton's opponent in a discussion about the nature of gravity in Newton's letter in 1776 to Robert Hooke. Hooke was a short, hunchbacked man on whose shoulders one would not want to stand. Even if one did stand on his shoulders, one would not see far. Knowledge thus develops as much in a social context as it is cumulative. The literature on the sociology of science has made this clear (Mäki, 1993). There are at least two other characteristics of knowledge that entail that in assessing welfare effects, one needs a perspective that takes dynamic processes by which knowledge develops into account. The development of knowledge involves tacit dimensions, and requires coding and decoding. These four characteristics are at work at the individual, the organizational,1 the regional2 as well as at a societal level (Mokyr, 2002). As at the latter three levels the knowledge development essentially involves individuals too, I will discuss this at some length. In addition, as the welfare perspective introduced below will take social welfare of a community (society) as a touchstone, the implications of the characteristics of knowledge development for the dynamics at the societal level are discussed as well. Knowledge differs from information (data) in that it needs to be interpreted to make sense of. Polanyi (1983) has developed a theory of knowledge acquisition that should also be of interest to economists (see Scitovsky, 1977, but also social psychologist Bandura, 1986). Polanyi (1983, p. 7) argues that (tacit) knowledge is acquired in a process he calls ‘subception.’ Any piece of information to be transplanted from one person to somebody else is ‘recepted’ (ibid., p. 5) by this other person and integrated or ‘subsumed’ into a larger framework of knowledge in which meaning is given to this new piece of information (ibid., p. 19). To the extent that information is subsumed (and it has to be subsumed if it is to have any meaning) into a larger framework of knowledge, it is interiorized (ibid., p. 29), as it were, to become a part of the body (cf. Douglas, 1986, p. 13). From this, it follows that man cannot always accurately state what it is that he knows about a certain topic. Such knowledge is typically “fraught with further intimations of an indeterminate range” (Polanyi, 1983, p. 23), constituting what might be called a ‘mountain of experience’ (Dolfsma, 2002). Where knowledge relevant to the particular subject becomes irrelevant is difficult to ascertain; there is a difficulty of separating relevant from irrelevant knowledge. Veblen (1961, p. 74) goes even farther than this in asserting that man is “a coherent structure of propensities and habits” (cf. Dolfsma, 2002). Prior knowledge is thus needed to acquire knowledge, but additional information does not necessarily increase one's knowledge: there are costs involved in storing knowledge. Knowledge building is not automatic, but involves being able to discern patterns. Despite having the same information, people might hold different views of the world, which can make communication difficult (costly) as decoding needs to occur. In addition to any decoding that might be necessary, communication (transfer of knowledge) is costly in itself as well. Separating the knowledge one needs to communicate can be costly, while the means used to communicate can also involve costs for the sender. Such a view of knowledge and information differs from the one generally subscribed to in economics. Here, the idea is that additional knowledge will reduce noise (see Denzau and North, 1994). Persistently diverging learning paths, such as those between A and B in Fig. 1 are excluded. The analogy between the view of the process by which an individual learns that would allow for persistently diverging learning paths and the view on the development of technological paradigms ( Dosi, 1982 and van de Poel et al., 2002) is striking. This certainly holds true when discussed in the terms ‘body of practice’ and ‘body of understanding’ suggested by Nelson (2004) when analysing the ‘advance of technology.’In a recent book Mokyr (2002) has argued that the industrial revolutions need to be explained by the development, but mostly by the diffusion and use of new knowledge. There are a number of noteworthy observations Mokyr makes about the role of knowledge for economic development. A first one is that there have been striking macro inventions before the first Industrial Revolution in England. None of these inventions gave rise to sustained economic growth, however. Another observation is about the way in which bodies of knowledge relate to one another. Fig. 2 is a framework that Mokyr suggests to understand the role of knowledge in the economy and in society. Propositional knowledge is knowledge about ‘how to manipulate nature’ (Mokyr, 2002); this includes more than what we would now call academic knowledge. Savants posses this type of knowledge. Prescriptive knowledge contains concrete directions about how to solve a particular problem; it is useful knowledge possessed by fabricants. Developments in both types of knowledge may stimulate one another. Mokyr explains this by pointing out that the knowledge base of economies (propositional knowledge) then can be too limited, the knowledge available can be not ‘tight’ enough to convince people to invest in the creation of new products or processes based on prepositional knowledge. Simply adding to what is known in a field will not result in a ‘tightening’ of the knowledge base.Thus, it can be considered a coincidence, in a way, that England around 1780 was the first country where sustained economic growth based on the use of newly developed knowledge could be observed. England was by no means the most technologically advanced country, and indeed it used knowledge developed in countries such as France extensively. Mokyr points to the institutions of English society that lowered the costs of communication about new knowledge. The result was that knowledge was much more readily exchanged among savants, among fabricants, and between these two groups. Thus, new knowledge was more easily created, but most importantly existing knowledge was put to good use faster, even if the knowledge would be of a tacit nature (cf. Cowan et al., 2000). Communication then, in Mokyr's argument, will both broaden and tighten the knowledge base of propositional knowledge, and stimulate the development of techniques (prescriptive knowledge) that find an immediate application in society and stimulate economic activity. Central in Mokyr's analysis is his concept of the ‘access costs’ people face when in need of ‘useful knowledge’. Knowledge may affect a firm's processes in other ways too. Knowledge can be recognized as immaterial assets in a firm's financial accounts, acknowledging its importance as productive factor. Introducing knowledge in a firm's financial accounts allows it to use it as collateral in capital markets. Accounting rules to be implemented in 2005 in Europe, following the American example, clarify this hitherto murky situation (Lev, 2001). Intellectual property (knowledge made exclusive) also plays an increasingly important role in strategic manoeuvring between firms (Lev, 2001 and Shapiro and Varian, 1999, Granstrand, 1999). IPRs may make a firm an inevitable player in a network, and it may allow a firm to exclude others from a network. This does not only hold for IPRs, but also for trade secrets and tacit knowledge, as long as access or use of such knowledge can be restricted. Economists have argued that agents need incentives to be persuaded to develop new knowledge. If such incentives – primarily in the case of a system of Intellectual Property Right (IPR) laws – would not exist, there would be an undersupply of new knowledge and basic knowledge in particular (Nelson, 1959). This argument is made both in case of patents, as well as in the case of copyrights (Landes and Posner, 1989). Without incentives, agents would not develop new knowledge, or would not make it publicly available. Nevertheless, it is known that firms do engage in fundamental research and have good reasons for doing so (Rosenberg, 1990), even when they know they cannot receive a patent to legally prevent others from commercially exploit the knowledge. In addition, not all firms find it worthwhile to apply for a patent (Arundel, 2001 and Levin et al., 1987). Increasingly, the arguments legitimising a system of IPRs have shifted to emphasizing the need for these institutions to offer protection so that investments in production facilities can be recouped before copycats who had to spend less in developing a product than the innovator enter the market (Hettinger, 1989). The discussion is a heated one, both in academia and beyond. Economists approach this discussion using Paretian welfare theory.

A knowledge-based economy needs a welfare theory that is able to grasp and evaluate its dynamics. In this article, I have taken suggestions from Schumpeter for a dynamic welfare economics and developed some ideas for a dynamic welfare economics. These ideas acknowledge the role of knowledge for an economy. As knowledge develops cumulatively in direct interactions between people, and is not simply available off the shelve where it winds up like manna from heaven to be put to use freely, the costs of communication has a strong impact on the creation and diffusion of knowledge, and the social welfare of a country. I distinguish storage, decoding and transmission costs related to communication of knowledge, to indicate that changes in these costs will affect (future) social welfare. Recent developments in Intellectual Property Rights in the terms of their effect on communication costs, turn out to be debatable. Changes in IPRs increase the costs of communication and could therefore be a potential impediment for the dynamics of the economy, and thus for future social welfare. The conclusion drawn by Romer (1993, p. 66) that an economics of ideas requires “a policy of openness with few distortions” would thus find support (cf. Nelson, 2004).