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Lecture 9.2: R&D and Innovation
Industrial Organization
2
Objectives of this lecture
To understand What is Innovation? Does competition increase or decrease the
incentive to engage in R&D? Why do we need a patent system? Should we allow rival firms to cooperate by
forming R&D joint ventures?
3
Example of an Innovation: Johan Neeskens of the Netherlands - 1974
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Example of an Innovation: Leininger and Ockenfels (2008)
Before 1974 world cup football, there were 2 strategies of a penalty shooter: shot Left or Right; and the goalkeeper: jump L or R
Johan Neeskens shot ‘straight’ in 1974 final This means - now there are 3 strategies for
each : Left, Right or Straight; and theoretically this increases the chances of goal by 11%
Fact check: Goals in penalty increased by around 11% in reality after 1974 !!!
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What is Innovation? Introduction of new commodities; introduction
of new ways of producing old commodities Product innovation introduces a totally new
commodity (e.g. a horseless carriage) or changes the outward characteristics of an old one (colour TV replacing the old black-and-white one)
Process innovation reduces the cost of turning out an existing product (e.g. as where an automatic machine replaces a hand-powered weaving loom)
R&D is the creative work to make innovation
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Easy way to see R&D
Firm 1 Firm 2
R&D R&D
Product innovation and /or process innovation
Final market competition
Profit Profit
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How might society reward inventors?
Salaries or prizes But moral hazard for effort and no incentive for
commercial/consumer benefit Temporary monopoly
E.g. secrets, patents, copyright Incentive to maximise profit… …return to issue of consumer benefit later (i.e.
‘appropriability’)
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The innovation process
Basic science (universities, research institutes) technological opportunity
Applied R&D (firms, joint ventures) products (capital goods, consumer products) processes (lower costs)
Imitation (by other firms)
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Creative destruction (Schumpeter)
Process by which good products become monopolies only for their success to be ‘destroyed’ by a
better product that is developed with the prospect of capturing a lucrative market.
Such competition affects the very lives of incumbent firms, not just marginal profit But beware of monopolists creating entry
barriers to thwart this process! Concentration = higher R&D Does this mean we need short run inefficient
monopolies to ensure much more important long term growth?
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Another Schumpeterian View
Large firms are able to spread fixed cost of research over a larger sales base
Large firms have advantages in financial markets
Large firms are better able to exploit economies of scale and scope in research
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Replacement effect (Arrow)
Firms earning economic profit will have less to gain from innovation than firms that do not earn economic profit, all else equal. Smaller firms have more incentive to invent
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Which current market structure gives greatest incentive to invest in R&D?
Competition
Unchallenged monopoly
Monopoly threatened by entry in patent race entrant would share duopoly market
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Ex ante Monopoly vs Competition incentive
Monopoly incentive = π1 – π0
Competition incentive = π1
Greater incentive if initial competition Unless financial constraints
Demand
P0
P1
Price
Quantity
π0
π1
C0
C1
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Monopoly threatened by entry in patent race
Suppose entrant could expect πD post entry Also monopolist Competition reduces profits so: πM > 2πD
Suppose biggest spender wins patent race Then monopolist has incentive to pay a bit more
to win the patent race otherwise it would lose more than entrant gains:
Gross benefit to monopolist of winning > incumbent profit if entrant wins
(πM – πD) > πD So incumbent spends πD + ε on R&D to win
patent race And make profit of: πM – πD – ε
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How can temporary monopoly be exploited?
Monopoly production by inventor
Licensing to other producers
Note: transaction costs are important in determining which is used (e.g. can idea be patented or is it protected by secrecy?)
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Licensing vs post-invention monopoly
Licensing incentive = unit fee * units sold = π1
Produce-it-yourself incentive = π1
But difference in who bears the risk!
License fee per unit sold
P0
P1
Price
Quantity
π0
π1
Units sold
C1
C0
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Weak empirical relationship between R&D and concentration
But be careful in interpreting this! Causation goes both ways
R&D/Sales
Concentration
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Market structure in R&D intensive industries
Patent race results in concentrated markets either with stable leader (persistence) or turbulence (leapfrogging)
Even with non-competing patents, competition escalates R&D to reduce costs high R&D overheads result in (i.e. cause)
concentrated markets rather than vice versa [See previous lecture]
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Some empirical (non-)relationships
Schumpeter was right about the importance of creative destruction, but not about the details. He claimed that:
Concentrated markets are more innovative because they generate profits to fund R&D Not true: see discussion of relationship
between R&D and concentration Large firms are more innovative because
they have the funds and scale for innovation Not true: yes for some highly capital-
intensive industries but small firms are better in skill-intensive industries
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Some examples…
Some small innovators that made it big: Xerox (photocopier); Apple (PC); Intel (micro-
chip); Google (search engine); Amazon (internet sales); e-Bay (internet exchange)
Some big firms that might have invented these products but did not: Kodak; IBM; GE; Microsoft; Walmart or Tesco;
Exchange & Mart magazine
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Productivity and competition I In UK manufacturing, more rapid productivity
growth when firms face more competitors (or have lower profit margins) Econometric evidence Similar results in service sectors
Deregulation and privatization have resulted in higher productivity growth in numerous industries and countries E.g. telecoms, electricity, airlines
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Productivity and competition II
Opening up to import competition raises productivity E.g. Single European Market Export opportunities more likely to be taken by
more productive firms which then grow – but exports do not ‘cause’ productivity growth
More rapid productivity growth in US petrol refining after break-up of Standard Oil a century ago Compare slow productivity growth in
monopolised US steel
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Digging deeper into how competition raises productivity
Recent ‘micro-data’ studies of thousands of individual establishments show…
Competition does not raise productivity of all business units
Strong ‘selection’ effect Productive units grow Inefficient units decline and exit New capacity tends to be more efficient
This is how Schumpeterian competition really works!
Note the importance of exit
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Appropriability - does the market provide the right incentive to inventors
Monopoly incentive = B Social gain if monopoly inventor = A + B Conventional welfare loss = C Too little R&D because firms consider only profits,
not consumer surplus
DemandPM
PC=MC
Price
Quantity
A
B C
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Issue in R&D: Spillovers
An entrepreneur commercializes knowledge but followers imitate the innovation
This erodes economic profit and the innovator is worse off
But spillovers improve static market performance as the product is supplied in a more competitive market
But entrepreneurs anticipate this and make less R&D investment – dynamic loss in welfare
Needs to be a balance
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R&D joint ventures and benefits
JVs can be socially beneficial…
‘Spillovers’ create a positive externality Free riding by rivals further reduces the incentive
for R&D Some competitive R&D may be duplicative Some R&D projects may be too large and risky
for a single firm
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R&D joint ventures and dangers
But JVs can also have adverse effects…
Absence of competitive pressure reduces the speed of research
Reduced total R&D if firms would each have done some individually
Cooperation might be carried over into pricing of end products
28
Quick review and more…
We discussed R&D What is innovation and R&D? Relationship between competition and R&D Schumpeterian views Issues of patent system and RJV
Read and solve: Martin - ch 14; Carlton and Perloff - ch 16. Lipczynski et al – ch 16
Advanced: Pepall et al. – ch 15