Industrial Organisation

Industrial Organisation

Seminar 7 Innovation and Technological Change

1. Explain the distinction between the basic research, applied research, development, commercial production and diffusion stages in the commercial application of a new technology. Basic Research

Basic research corresponds to the invention stage in the Schumpeterian trichotomy. At its extreme, basic research may be carried out without any practical application in view.

For example, early research in molecular physics was carried out without any foreknowledge of the use of the valve in broadcasting and communications. Industrial firms may be reluctant to undertake basic research, due to the uncertainty of outcome. Consequently, basic research is often the province of government agencies and universities. In a study of the petroleum and chemical industries, Mansfield (1969) finds only about 9 per cent of the firms total research and development expenditure was on basic research, while 45 per cent was on applied research and 46 per cent on development.

Applied Research

Applied research has a stated objective. Following an investigation of the potential economic returns, research is under- taken to determine the technological feasibility of the proposed application.

Development

Generally this can be considered as the bringing of an idea or invention to the stage of commercial production. At this stage, resources are heavily committed, and pilot plants or prototypes may have to be built. Although it is clear that at every stage of research and development the firm must review its progress, it is at the development stage that the selection process for the next (commercial production) stage is most important. The failure of a new product that has already entered into commercial production would be very costly to the organization.

Commercial Production

This stage refers to the full-scale production of a new product or application of a new process. Regardless of the amount of research and development already undertaken, there is still a large element of risk and uncertainty. A major difference between invention and innovation arises from the level of risk involved: the main interest of the inventor is in the generation of ideas and not the production of goods and services on a commercial basis. Together, the applied research, development and commercial production stages correspond to the innovation stage in the Schumpeterian trichotomy.

Diffusion

The final stage refers to the spread of the new idea through the firm, as well as the imitation and adoption of the innovation by other firms in the same industry, or in other industries where the innovation may be applicable. There is also a spatial element to the diffusion process, as ideas spread geographically through foreign direct investment, licensing agreements or joint ventures.

An important distinction is often drawn between product and process innovation. A product innovation involves the introduction of a new product. A process innovation involves the introduction of a new piece of cost-saving technology. However, the distinction between product and process innovation is not always clear cut. New products often require new methods of production; and new production processes often alter the characteristics of the final product. Furthermore, one firms product innovation may be another firms process innovation. For example, a new piece of capital equipment might be classed as product innovation by the producing firm; but from the point of view of the user, the machine would represent a process innovation.

2. Is the level of effort devoted to research and development likely to be any higher if an industry is monopolised than if it is perfectly competitive? Consider this with reference to the debate between Arrow and Demsetz. Monopoly

In favour of monopoly, one can point out that firms in highly concentrated industries may earn abnormal profits, which can be invested in risky research and development programmes. Firms in more highly competitive industries may earn only a normal profit, leaving no uncommitted resources available to finance speculative investment in research and development. Furthermore, the lack of competitive pressure in a monopoly creates an environment of security, within which it is possible for the firm to undertake high-risk investment in projects whose returns may be uncertain at the outset. In the event that the investment succeeds, there is less risk of imitation; and in the event that the project fails, there are no rivals waiting to step in and take advantage of the firms temporary financial difficulties (for example, by initiating a price war at a time when the firms ability to sustain losses might be diminished). In other words, the lack of competitive pressure gives the firm the time and space it needs to develop and grow.

Perfectly Competitive

In the absence of competitive pressure, the managers of a monopoly firm might tend to become complacent or lazy; or excessive internal bureaucracy within the firms organizational structures might lead to a loss of managerial control, or other forms of technical inefficiency (x-inefficiency). Another line of reasoning suggests the probability of a successful product or process invention emerging is positively related to the number of research teams that are simultaneously working on similar a idea or challenge. Under a competitive market structure, there may be more research teams competing to be the first to come up with a solution, and therefore a higher probability that at least one of these teams will succeed. Finally, a monopolist that owes its market power to a successful innovation in the past may be so tied to its existing technology that to switch resources to a new product or process would be considered too costly. A slightly more subtle variant of this final argument in favour of competition points out that if a new piece of technology displaces a monopoly firms current technology, the monopolists incentive to innovate is governed by the net effect on its profit. Under a competitive market structure, the incentive to innovate is governed by the gross return from the innovation. Accordingly, the incentive to innovate may be greater under competitive conditions than it is under a monopoly.Arrow (1962) Arrow compares the impact of a cost-saving process innovation under market structures of perfect competition and monopoly. In both cases, constant returns to scale and horizontal LRAC and LRMC (long-run average and marginal cost) functions are assumed. The innovation causes a downward shift in the position of the LRAC (=LRMC) function. Under perfect competition, it is assumed the inventor charges each perfectly competitive firm a royalty per unit of output for use of the cost-saving technology. The inventors return is the total value of the competitive firms royalty payments. Under monopoly, it is assumed the monopoly firm itself is the inventor. The inventors return is the increase in abnormal (or monopoly) profit realized due to the adoption of the cost- saving technology.

Concludes that the incentive to invent or innovate is greater under perfect competition than it is under monopoly.

Demsetz (1969)

Because the pre-innovation output levels of the perfectly competitive industry and the monopoly are different, Arrow fails to compare like with like. Arrows comparison tends to favour the perfectly competitive industry because the benefits of the cost-saving technology are spread over a larger volume of output than in the monopoly case. In order to make a fair comparison, we should set aside the usual tendency for a monopolist to produce less output than a perfectly competitive industry. Instead, the comparison should be based on an assumption that the pre-innovation output levels are the same under both market structures.

In other contributions to the ArrowDemsetz debate, Kamien and Schwartz (1970) argue that a fair comparison between the incentives to invent and innovate under perfect competition and monopoly should be based on a starting position at which not only the industry output levels, but also the price elasticities of demand, are the same. This is not the case in Figure 14.3: the monopolists demand function (DM) at (P1, Q1) is more price elastic than the perfectly competitive industrys market demand function (DC) at (P3, Q1). In an analysis that assumes identical preinnovation output levels and price elasticities, Kamien and Schwartz show the incentive to innovate is stronger under monopoly than it is under perfect competition. Yamey (1970) observes Arrows analysis focuses solely on a cost-saving innovation. Therefore Arrow does not con- sider the case of a completely new innovation, which allows production of a good that was previously either uneconomic or technologically infeasible. In this case, the assumed pre-innovation output level under both market structures is the same: zero. With zero pre-innovation output, the incentive to innovate is identical under perfect competition and monopoly.

3. What factors are relevant to a firm in determining the speed at which it intends to execute a planned research and development programme? Why might the market structure in which the firm operates be relevant in this decision? Demand Perhaps the most fundamental issue is whether the new idea meets an unsatisfied market demand. This is not always as difficult as it may sound, since in some cases it may be customers who alert their suppliers to a gap in the market. For example, Minkes and Foxall (1982) find that a large proportion of research and development is stimulated by requests for product or process improvement from users.Costs

Given that the full costs of development projects are often uncertain and spread over relatively long durations, it is difficult to produce reliable cost estimates. The uncertainty can be reduced by concentrating on less speculative projects, but even then the likelihood of error is high.

Finance

The returns from investment in research and development and innovation are un- certain and difficult to estimate. The managers initiating the research probably have more information as to the likely success of the project than the financier. Therefore it may be difficult to raise finance externally, and the firm may need to rely mainly on internally generated funds. Consequently research is often underfunded

Employee or trade union resistance

Organized labour might attempt to resist the adoption of a new technology, if they view it as a threat to their employment. For example, in the 1970s print unions in the UK were reluctant to accept technology which allowed journalists to electronically transfer their copy direct to the photosetting department, bypassing the composing rooms. Also look into Belfast shipyards.Regulation

If an industry is subject to a cumbersome regulatory framework, which perhaps requires standards for materials, design and safety, the adoption of a new technology may be sluggish, because amending the regulations may be a slow and bureaucratic process. For example, Oster and Quigley (1977) find local building codes significantly reduced the diffusion of new technology in the construction industry.

Patents

In a free market, new knowledge is a free resource, available to all firms. A possible consequence is that there may be too little, or no research and development, as the firms undertaking the investment would be reluctant to see free-riders reap the benefits of the knowledge acquired from costly and risky research and development investment (Gallini, 2002). Accordingly, governments offer patents to protect innovators from over-rapid diffusion.

The Schumpeterian hypothesis is often interpreted in terms of an association between market structure and the pace of technological change. However, this hypothesis is also consistent with the idea that only large firms have the resources to implement the large-scale research and development programmes that are required to generate ideas for new products and new production processes, and to develop these ideas to the point that they are capable of being implemented commercially. The argument that technological change is most likely to be driven by large firms rather than small firms or independent inventors is based mainly on economies of scale or scope (in one form or another) in research and development, or in adjacent functions such as finance.

The empirical evidence for a positive association between firm size and the level of inventive or innovative activity is not particularly strong, and in some cases it may even point in the opposite direction. For example, Hamberg (1966) finds only seven out of 27 major inventions during the period 194755 emanated from company research and development departments. In a more extensive study covering 61 major inventions during the period 190056, Jewkes et al. (1969) find that the majority emanated from small private inventors, rather than from the research departments of large firms.

4. What factors should be considered by policy makers when deciding the duration of patents? Is it possible that patents might slow the pace of technological change? Patents give incentive to invent by creating opportunity for inventor to earn monopoly rent.

Implies socially sub-optimal utilisation of innovation.

Optimal patent period is shorter:

The higher the price elasticity of demand for the product;

The greater the benefit yielded by a given unit of R&D expenditure.

The key is to find a balance between the innovators ability to earn a return on its R&D investment and the benefits that will accrue to consumers once the patent expires and competition merges.

A rational patent office will realise that its choice of the time a patent is in effect, will also affect the firms choice of R&D effort. Therefore the best way to do this is for the patent office to determine the innovators profit maximising research intensity, x*(T), as a function of T.

To choose the optimal T, the patent office will wish to pick the patent duration that maximises the net social gain to both consumers and producers given how the firms choose their research intensities.

Optimal patent duration is finite. As the patent office increases initially the patent duration it induces greater R&D effort, and at first, a greater discounted net surplus to producers and consumers. Beyond some point however, continued increases in T will reduce net social surplus even though they lead to more R&D and therefore greater reductions in production cost. This is because whilst R&D may be still increasing, an excessive patent period may stifle other technological advancement in the same area,.

Two forces work to limit the optimal value of T. First is our assumption of diminishing returns to R&D activity, because it becomes progressively more expensive to lower production costs, it will take progressively greater increases in T to achieve a given additional cost saving. The second force limiting optimal patent duration is discounting. Consumer benefits of an innovation may be not fully realised until a patent expires. Yang and Tsou (2002) examine the propensity to patent following a change in the Taiwanese patenting system in 1994, which increased the duration of patents. Although the number of patents increased after the change, this may have been mainly due to factors other than the change in duration.5. What does empirical evidence suggest about the relationship between firm size and the rate of technological innovation? Is this evidence supportive of Schumpeters theory of technological advance?

Symeonidis (1996) Over the 1956-1983 period, innovation intensity increased steadily for firms with less than 500 employees and declined for firms with more than 500 and less than 10000 employees. Hence, small firms were important innovators, and increasingly so. For example, during the 1960s innovative intensity was highest in the 1000-1999 and 50000+ size classes, while in the late 1970s and early 80s it was highest in the 100-199, 200-499 and 50000+ size classes. It should also be noted that, as these numbers suggest, the very largest firms were consistently the best performers throughout the 1956-1983 period.

The review shows that there is little evidence in support of the Schumpeterian hypothesis that market power and large firms stimulate innovations: R&D spending seems to rise more or less proportionally with firm size after a certain threshold level has been passed, and there is little evidence of a positive relationship between R&D intensity and concentration in general. However, positive linkages between concentration/size and innovative activity can occur when certain conditions are met, including high sunk costs per individual project, economies of scale and scope in the production of innovation rents. Recent empirical work suggests that R&D intensity and market structure are jointly determined by technology, the characteristics of demand, the institutional framework, strategic interaction and chance.