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.

- Schumpeter’s (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 monopolist’s 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(£60x£20)=) £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.

- Arrow’s 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 Arrow’s 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 Arrow’s 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-à-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=C0+C1(1+r) + C2(1+r) 2 + …+ Cn(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=B0+B1(1+r) + B2(1+r) 2 + …+ Bn(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, Arrow’s 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 1990’s, 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 Schumpeter’s 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 90’s: 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 Audretsch’s (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 1970’s 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.