Innovation

- Important to distinguish between the different stages of development of a new commercial

product or process
- Many major technological changes begin with basic research, which is research aimed at
gaining knowledge for its own sake. The next stage is applied research, which is aimed at
obtaining knowledge with the objective of using that knowledge for commercial purposes.
Successful applied research results in invention or the discovery that the idea should work,
passing it through rough tests. The next stage in the process is innovation, which is the first
commercial application of the invention, and requires refinement of the invention to develop
a marketable product. Large R&D labs spend much time on innovation. Finally, diffusion is
the stage at which the innovation comes into common use.
- Private firms are primarily engaged in these latter stages of technological development,
whereas most basic research is carried out at academic and non-profit institutions and by the
government.
- Schumpeters (1942) thesis was revolutionary. He argued that from the standpoint of
dynamic efficiency, perfect competition was not the ideal market structure, but instead large-
scale firms with monopoly power became the superior market structure. Creative destruction
drove a capitalist economy forward in the long-run, and large-scale monopolists engaged in
research and development led to creative destruction, as diffusion of new waves of
innovations brings the bankruptcy of those that lag behind. In the Schumpeterian world
(unlike the neoclassical one), large firms with monopoly power (not perfect competition)
ensured long-run growth.
- This argument spurred economists to examine the issue both theoretically and empirically.
- Schumpeter argued that the speed of innovation is faster in large firms than small ones
Kenneth Arrow did not agree.
- Arrow developed the following model: suppose two markets have identical demands of
P=100-Q. Industry 1 is a monopoly and Industry 2 is perfectly competitive. What is the
impact of a cost reduction by the monopolist? (DRAW DIAGRAM)
- If the monopolists costs decrease from MC=AC=30 to MC=AC=20, the price decreases
from 65 to 60 and profits increase from (Q (P-AC)=35(65-30)=) 1225 to
(40(60x20)=) 1600, so profits increase by 375, as a result of the introduction of the cost-
saving innovation, and consumer surplus also increases, as P declines and Q increases
- Now consider a market of perfect competition: initially MC=AC=30 and the perfectly
competitive industry set Q=70 and P=30, and as such, profits equal 0. Suppose someone has
the property rights on an innovation (i.e. a patent). The innovation reduces MC from 30 to 20.
She has the choice either to exploit the patent herself, which means that she drives out her
competitors with a price just beneath 30, or she can sell her competitors a license. The worth
of the payment is easy to see (the cost reduction times the perfectly competitive output), so
the innovator sells it for this price and everything remains the same (i.e. the price remains at
30 and producers continue to earn supernormal profits). The innovator earns an economic
rent of 700 as a result of the introduction of cost-saving device. The entire economic rent
accrues to the patent holder.
- The innovator from the perfectly competitive industry earns almost twice as much from the
new innovation as the monopolist, therefore has a greater economic incentive to develop the
cost-saving device.
- Arrows conclusion runs contrary to the Schumpeterian view.
- So far analysis has centred on whether monopoly or perfect competition is likely to result in a
rapid rate of technological advance. The introduction of oligopoly makes the analysis more
realistic.
- Investments in research and development require both an incentive and an ability to invest.
- Under perfect competition, economic profits are normal, and there is little ability to invest in
R&D, and incentives to innovate are moderate. In Arrows model the PC firm has a powerful
incentive to invest in R&D, but one problem that is not accounted for is that diffusion is rapid
in PC markets, therefore profits decline quickly to normal, reducing the incentive to invest.
- In a monopoly, profits may be greater than zero for long periods, giving the monopolist the
ability to invest large sums in R&D (e.g. Microsoft). With regard to incentives, the
monopolist has low-to-moderate incentive, as it has 100% of market share and is protected
from competition, it will therefore have limited concern about the time at which it introduces
a new technological advance. As shown by Arrows model however, the monopolist can earn
additional profits from an innovation, and therefore still has some incentive to invest in R&D
- In terms of ability, oligopoly lies somewhere in between. Depending on the level of effective
competition, oligopolists may or may not have the profits available to invest in R&D (e.g. of
those that have earned LT positive profits include: computer equipment, automobiles,
electronics etc). Oligopolists have both the ability and incentive to invest in R&D. They have
an incentive to invest because they gain vis--vis rivals by being the first to develop a new
product or process. The expected moderate rate of imitation in oligopoly gives them the
largest incentive to invest (e.g. Miller Beer and Miller Lite gained a larger market share)
- Scherer developed a formal model relating the rate of technological advance to market
structure. The model compares the present value of costs and benefits associated with a new
technological advance under different market structures.
- There is a time-cost trade-off associated with R&D. The present value of the cost of
development can be identified as: C=C
0
+C
1
(1+r) + C
2
(1+r)
2
+ + C
n
(1+r)
n

- R&D costs are front-loaded. When speeding up the process we easily get diminishing returns
on the research unit and speeding up the process will increase the present value of the
expenditures
- The benefits of R&D depend on time: B=B
0
+B
1
(1+r) + B
2
(1+r)
2
+ + B
n
(1+r)
n

- These benefits are a declining function of time. The present value of the pay off gets smaller
as time proceeds before the innovation is installed and once the innovation is brought out,
competitors will try to imitate it
- Given the expected benefits and costs of R&D, it is possible to determine an optimal time for
research (DRAW DIAGRAM) a monopolist does not have to fear the diffusion of
technology, therefore has a long time horizon (shallower benefits curve), whereas the
oligopolist that fears imitation and the diffusion of technology, has a rather short time
horizon, therefore oligopolies innovate faster!
- In the same way, reducing the costs of innovation speeds up the introduction of innovations.
- To summarise: the threshold interpretation of Schumpeter is that a firm needs to be a certain
size to be able to innovate at all. Monopolist can co-ordinate more organised research project,
have the funds to do this and will do this as they have a long-term view and want to protect
their position. Arrow and to some extent Scherer believe that some degree of imperfect
competition is necessary to breed innovation. Monopolists can slack, whereas oligopolists,
with their fear of imitation and the desire to achieve short-term abnormal profits, are
constantly innovating. The competitive firm stands to gain more, so has more incentive to
innovate.
- However, Demsetz (1969) criticised Arrow for assuming in his analysis that the post-
invention output level of the two industries is equal and showed that if the industries were
producing the same output level prior to the invention, the increase in profit resulting from a
cost-reducing invention is greater in the case of monopoly, the opposite conclusion to that
reached by Arrow.
- Kamien and Schwartz (1970) find that the incentives depend on the market structure and on
the price-elasticity of demand.
- Ng (1971) offers to counter argument to this by demonstrating that when both the pre and
post-invention output levels in the two industries are equal, which occurs when demand
conditions facing both industries are identical and cost-reductions are proportionate, Arrows
conclusion that the incentive to invent is smaller under monopoly remains valid.
- Theoretical studies: Louly (1979) and Dasgupta and Stiglitz (1980) studied the effects of
market competition on innovative activity using game theory and showed that firms in
competitive markets are more likely to over-invest in R&D. On the other hand, Gilbert and
Newberry (1982) showed that firms, which dominate a product market, have an incentive to
innovate in order to maintain their monopolistic position. And in the 1990s, Grossman and
Helpman (1991) and Aghion and Howitt (1998) constructed growth models where
competition and innovative activity where endogenised. These growth models support the
Schumpeterian hypothesis that more monopolistic firms are likely to be more innovative
- Empirical studies: support for the Schumpeterian view is mixed. Teece (1996) believes that
competition is key to innovation, and is quick to dismiss Schumpeters argument. He
identifies that venture capitalists provide money to small, entrepreneurial firms and that there
is a near perfect capital market, therefore he believes the assumption that monopolies have
higher cash flows compared to competitive firms is wrong.
- There was a wave of further empirical studies in the 90s: Nickell (1996) studied the effect of
market structure on TFP by using UK firm level data from 1972-1986. By estimating a
production function that includes independent variables representing market structure, he
showed that market competition promoted the productivity growth of firms.
- Acs and Audretschs (1990) empirical analysis across a wide spectrum of manufacturing
industries highlighted the increased importance of small firms in generating technological
innovations and their growing contribution to the US economy, finding that most socially-
changing inventions are carried out by small players (i.e. the spark of innovation takes place
inside the research labs of small firms)
- Geroski (1990) used data on major innovations introduced in the UK during the 1970s and
find fairly strong evidence against the hypothesis that increases in competitive rivalry
decrease innovativeness. Blundell, Griffith and Val Reenen (1999) used count data on
innovation and patent data instead of TFP as their dependent variable. Their estimation
results found that market share has a positive impact on firms innovative activities, although
the concentration ratio has a negative impact. Additionally, their results suggest that cash
flow does not affect innovative activities, supporting the idea that market competition
stimulates innovative activity (i.e. positive effect of competition on innovation), contradicting
the theoretical predictions of Schumpeter.