13 microeconomics of “the new economy”: innovation and growth the bourgeoisie [i.e., capitalism]...

13Microeconomics of “The

New Economy”: Innovation and Growth

The Bourgeoisie [I.e., capitalism] cannot exist without constantly revolutionizing the instruments of production. . . . The

bourgeoisie, during its rule of scare one hundred years has created more massive and more colossal productive forces than

have all preceding generations together.KARL MARX AND FRIEDRICH ENGELS,

THE COMMUNIST MANIFESTO, 1847

● The Free Market’s Incredible Growth Record

● What’s New about the New Economy?● The Firm and Innovation● Three Growth-Creating Properties of

Innovation● Do Free Markets Spend Enough on R&D

Activities?● Conclusion: The New Economy and the

Innovation Assembly Line

● The Free Market’s Incredible Growth Record

● What’s New about the New Economy?● The Firm and Innovation● Three Growth-Creating Properties of

Innovation● Do Free Markets Spend Enough on R&D

Activities?● Conclusion: The New Economy and the

Innovation Assembly Line

ContentsContents

Copyright© 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning All rights reserved.

The Free Market’s Incredible Growth Record The Free Market’s Incredible Growth Record

● Since the Industrial Revolution the growth in per-capita income and productivity in free-market economies has been enormous compared to the 1,500 years before the Industrial Revolution.

● Since the Industrial Revolution the growth in per-capita income and productivity in free-market economies has been enormous compared to the 1,500 years before the Industrial Revolution.


The Free Market’s Incredible Growth Record The Free Market’s Incredible Growth Record

● Innovation--♦ the process by which new products or new

methods of production are introduced, including all the steps from the inventor’s idea to bringing the new item to market.

♦ permitted growing outputs that enabled society to invest increasingly in productive plant and equipment and in education.

● Innovation--♦ the process by which new products or new

methods of production are introduced, including all the steps from the inventor’s idea to bringing the new item to market.

♦ permitted growing outputs that enabled society to invest increasingly in productive plant and equipment and in education.


The Free Market’s Incredible Growth RecordThe Free Market’s Incredible Growth Record

● Labor productivity = the amount of output a worker turns out in an hour (or a week or a year) of labor

● Over the long run, productivity growth is what counts most in raising living standards.

● Rapid innovation has been a constant feature of the modern industrial era.

● Labor productivity = the amount of output a worker turns out in an hour (or a week or a year) of labor

● Over the long run, productivity growth is what counts most in raising living standards.

● Rapid innovation has been a constant feature of the modern industrial era.

FIGURE 13-2 Declining Real Labor Price, Electronic Products

FIGURE 13-2 Declining Real Labor Price, Electronic Products


23

562

57 42 9

456 365

15 15 0.76

494

2,467

Cellular phone

1984/1997

Microwave oven

1947/1997

Calculating device

1916/1997

Home movie

camera 1960/1997

VCR 1972/1997

Color TV 1954/1997

Ho

urs

of

Wo

rk T

ime

Nee

de

d t

o P

urc

ha

se I

tem

s

0

500

1,000

1,500

2,000

2,500


What’s New about the New Economy?What’s New about the New Economy?

● Real expenditures on R&D by U.S. firms rose rapidly from 1970-1998.

● New innovations disseminated more rapidly.

● Real expenditures on R&D by U.S. firms rose rapidly from 1970-1998.

● New innovations disseminated more rapidly.

FIGURE 13-4 Increasing Real Expenditures on R&D

FIGURE 13-4 Increasing Real Expenditures on R&D


Year

Mil

lio

ns

of

1992

Do

llar

s

1990 1998 1995 1985 1980 1975 1970 0

$140,000

120,000

100,000

80,000

60,000

40,000

20,000



● Growth in Spending on Innovation and Speeding Up of Dissemination♦ Any firm that can come up with a better model

than rivals gains an advantage that its competitors cannot match as quickly and easily as a price cut.

♦ Research and development (R&D) is the means by which firms create new products and prepare them for market.

● Growth in Spending on Innovation and Speeding Up of Dissemination♦ Any firm that can come up with a better model

than rivals gains an advantage that its competitors cannot match as quickly and easily as a price cut.

♦ Research and development (R&D) is the means by which firms create new products and prepare them for market.



● Growth in Spending on Innovation and Speeding Up of Dissemination♦ Firms in “innovation arms race” – firms must

innovate in order to compete with rivals.♦ Many firms must spend large sums on R&D to

develop products that have low marginal costs.♦ Firms cannot follow marginal cost pricing rule

(P = MC) as it will not allow them to recover R&D costs.

● Growth in Spending on Innovation and Speeding Up of Dissemination♦ Firms in “innovation arms race” – firms must

innovate in order to compete with rivals.♦ Many firms must spend large sums on R&D to

develop products that have low marginal costs.♦ Firms cannot follow marginal cost pricing rule

(P = MC) as it will not allow them to recover R&D costs.



● Externality = incidental benefits or damages of an activity that affect others not directly involved in the activity.

● Network Externality = entry of an additional participant into a group of connected individuals or organizations benefits the initial members of a group.

● Externality = incidental benefits or damages of an activity that affect others not directly involved in the activity.

● Network Externality = entry of an additional participant into a group of connected individuals or organizations benefits the initial members of a group.



● Good Collusion Versus Bad Collusion♦ Design Compatibility = different network

components must be designed to work together.

♦ Gives rise to need for “good collusion” among firms to maximize benefits of new innovations.

● Good Collusion Versus Bad Collusion♦ Design Compatibility = different network

components must be designed to work together.

♦ Gives rise to need for “good collusion” among firms to maximize benefits of new innovations.



● Globalization♦ Globalization aided by speed of travel,

competition from foreign sources, new communication technologies.

● Globalization♦ Globalization aided by speed of travel,

competition from foreign sources, new communication technologies.


The Firm and InnovationThe Firm and Innovation

● If the firm seeks to maximize its profits, it will expand its spending on R&D up to the point at which its anticipated marginal cost of R&D equals its anticipated marginal revenue from R&D

● If the firm seeks to maximize its profits, it will expand its spending on R&D up to the point at which its anticipated marginal cost of R&D equals its anticipated marginal revenue from R&D

● Perfectly competitive industries permit firms to earn just what they need to pay investors for the funds they provide.

● Perfectly competitive industries permit firms to earn just what they need to pay investors for the funds they provide.

How Much Will a Profit-Max. Firm Spend on Innovation?How Much Will a Profit-Max. Firm Spend on Innovation?


● Due to barriers to entry for innovation, we cannot be certain that economic profits to invention will tend exactly toward zero, but we can still expect them to be very low on average.

● While inventive activity sometimes pays off enormously well, large R&D investments also can fail spectacularly, so that the average comes out close to zero.

● Due to barriers to entry for innovation, we cannot be certain that economic profits to invention will tend exactly toward zero, but we can still expect them to be very low on average.

● While inventive activity sometimes pays off enormously well, large R&D investments also can fail spectacularly, so that the average comes out close to zero.

How Much Will a Profit-Max. Firm Spend on Innovation?How Much Will a Profit-Max. Firm Spend on Innovation?


● Since only a small percentage of new products ever make it all the way to the marketing stage, we would expect firms to minimize their risks.

● One way firms try to protect themselves is by joining together in “research joint ventures” to share risks.

● Since only a small percentage of new products ever make it all the way to the marketing stage, we would expect firms to minimize their risks.

● One way firms try to protect themselves is by joining together in “research joint ventures” to share risks.

The Profits of InnovationThe Profits of Innovation


● Another arrangement is technology trading in which a firm voluntarily makes its privately owned technology available to other firms either in exchange for access to the technology of the second company, or on payment of an agreed-upon fee.

● Another arrangement is technology trading in which a firm voluntarily makes its privately owned technology available to other firms either in exchange for access to the technology of the second company, or on payment of an agreed-upon fee.



● Many firms and industries engage in the practice of cross licensing where each of two firms agrees to let the other use some specified set of its patents, either at a price specified in their agreement or in return for access to the other firm’s patents.

● Many firms and industries engage in the practice of cross licensing where each of two firms agrees to let the other use some specified set of its patents, either at a price specified in their agreement or in return for access to the other firm’s patents.



● Why do firms innovate?♦ Expensive and risky

♦ Expected economic profits approach zero

♦ If firms do not keep up with competitors in terms of product attractiveness and improved process efficiency that lowers costs, they will lose out to their rivals and end up losing money.

● Why do firms innovate?♦ Expensive and risky

♦ Expected economic profits approach zero

♦ If firms do not keep up with competitors in terms of product attractiveness and improved process efficiency that lowers costs, they will lose out to their rivals and end up losing money.

A Kinked Revenue Curve Model of Spending on InnovationA Kinked Revenue Curve Model of Spending on Innovation


● An asymmetry in the firm’s expectations about its competitors helps explain spending on innovation.♦ A firm expects mixed reactions from its

competitors: they will follow its lead in increasing R&D, but will not follow any decreases.

● An asymmetry in the firm’s expectations about its competitors helps explain spending on innovation.♦ A firm expects mixed reactions from its

competitors: they will follow its lead in increasing R&D, but will not follow any decreases.



FIGURE 13-6 Competition and R&D Investment



MR

an

d M

C

R&D Investment in Millions of Dollars

20 7 0

R

M

C

S

MC

B

m

r

R&D Spending not Matched

R&D Spending Matched

A

● All firms in an industry continue to invest same amount until one has research breakthrough leading to a new product.

● Firm then expands its investment in the breakthrough product, because doing so will pay off even if the other firms in the industry match the increase.

● All firms in an industry continue to invest same amount until one has research breakthrough leading to a new product.

● Firm then expands its investment in the breakthrough product, because doing so will pay off even if the other firms in the industry match the increase.



● This process, described as a ratchet, assumes that competition forces firms in the industry to keep up with one another in their R&D investment.

● Once caught up, investment level remains fairly level until one firm increases its spending, and all other firms follow behind.

● This process, described as a ratchet, assumes that competition forces firms in the industry to keep up with one another in their R&D investment.

● Once caught up, investment level remains fairly level until one firm increases its spending, and all other firms follow behind.



● This arrangement holds technological spending steady, permits it under certain circumstances to move forward, but generally does not allow it to retreat.

● This arrangement holds technological spending steady, permits it under certain circumstances to move forward, but generally does not allow it to retreat.






R1

M1

R2

M2

A

MC

MR

an

d M

C

R&D Investment in Millions of Dollars

25 20 0

C

B1

B2


Three Growth-Creating Properties of InnovationThree Growth-Creating Properties of Innovation

● Many innovations create cumulative changes.

● Technical knowledge has a public good property.

● Innovations enjoy an accelerator feature.

● Many innovations create cumulative changes.

● Technical knowledge has a public good property.

● Innovations enjoy an accelerator feature.



● Cumulative Innovation♦ The economy’s stock of technical knowledge

keeps expanding as new information is added to old.

● Cumulative Innovation♦ The economy’s stock of technical knowledge

keeps expanding as new information is added to old.



● The Public Good Property of Innovation♦ Technical knowledge can be used over and

over again without ever being depleted.

♦ A process innovation changes the way in which a commodity is produced.

♦ A product innovation introduces a good or service that is entirely new or involves major modifications of earlier products.

● The Public Good Property of Innovation♦ Technical knowledge can be used over and

over again without ever being depleted.

♦ A process innovation changes the way in which a commodity is produced.

♦ A product innovation introduces a good or service that is entirely new or involves major modifications of earlier products.



● The Accelerator Property of Innovation♦ Successful innovation adds to nation’s GDP

■firms create more products with given resources■makes new and more valuable products available

♦ Thus when R&D produces a steady output of innovations, GDP is higher each year.

♦ Cost-cutting process innovation ■increases output■decreases the price

● The Accelerator Property of Innovation♦ Successful innovation adds to nation’s GDP

■firms create more products with given resources■makes new and more valuable products available

♦ Thus when R&D produces a steady output of innovations, GDP is higher each year.

♦ Cost-cutting process innovation ■increases output■decreases the price

FIGURE 13-8 Higher R&D Spending Accel. GDP Growth

FIGURE 13-8 Higher R&D Spending Accel. GDP Growth


2125 2100

Y1

R1

R2

Y2

R&

D S

pe

nd

ing

an

d G

DP

Year

2075 2050 2025 2000

FIGURE 13-9 Effect of Process Innovations on Prices & Outputs

FIGURE 13-9 Effect of Process Innovations on Prices & Outputs


Pri

ce

Quantity of Widgets Produced

MC2

MC1

E2

E1

P2

Q2

P1

Q1

MR

D (AR)

D

0


Do Free Markets Spend Enough on R&D Activities?Do Free Markets Spend Enough on R&D Activities?

● As with any investment, R&D investment entails a trade-off between present and future.

● As with any investment, R&D investment entails a trade-off between present and future.



● Innovation as a Beneficial Externality♦ Because the acquisition of new technical

knowledge generates large beneficial externalities, private enterprise may not devote enough resources to innovation.

♦ Basic research refers to research that seeks to provide scientific knowledge and general principles rather than coming up with any specific marketable inventions.

● Innovation as a Beneficial Externality♦ Because the acquisition of new technical

knowledge generates large beneficial externalities, private enterprise may not devote enough resources to innovation.

♦ Basic research refers to research that seeks to provide scientific knowledge and general principles rather than coming up with any specific marketable inventions.



● Innovation as a Beneficial Externality♦ Applied research is research whose goal is to

invent or improve particular products or processes.

♦ The externality problem is probably most severe for basic research.

● Innovation as a Beneficial Externality♦ Applied research is research whose goal is to

invent or improve particular products or processes.

♦ The externality problem is probably most severe for basic research.



● Innovation as a Beneficial Externality♦ Because of the externality problem, the

governments of the United States and a number of other industrial countries provide money to finance basic research.

● Innovation as a Beneficial Externality♦ Because of the externality problem, the

governments of the United States and a number of other industrial countries provide money to finance basic research.



● Why the Shortfall in Innovation Spending May Not Be So Big After All♦ Technology Trading = firm makes technology

available to others in exchange for access to the other firms’ technologies or for fees. ■Allows greater profits to innovators, hence expands

innovation.

♦ Cross-Licensing = occurs when each of two firms agree to let the other use their patents, either for a fee or in a swap

● Why the Shortfall in Innovation Spending May Not Be So Big After All♦ Technology Trading = firm makes technology

available to others in exchange for access to the other firms’ technologies or for fees. ■Allows greater profits to innovators, hence expands

innovation.

♦ Cross-Licensing = occurs when each of two firms agree to let the other use their patents, either for a fee or in a swap


The New Economy and the Innovation Assembly LineThe New Economy and the Innovation Assembly Line

● More effective and fierce competition● New problems for prevention or control of

monopoly● More rapid resource depletion but also way

to use natural resources more efficiently● Left many economic problems unsolved but

raised standards of living and accelerated the rate of improvement in wealthiest countries

● More effective and fierce competition● New problems for prevention or control of

monopoly● More rapid resource depletion but also way

to use natural resources more efficiently● Left many economic problems unsolved but

raised standards of living and accelerated the rate of improvement in wealthiest countries

13 microeconomics of “the new economy”: innovation and growth the bourgeoisie [i.e., capitalism]...

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