ECONOMICS OF INNOVATION

Chapter III PERSPECTIVES ON INNOVATION

The impact of technological change �  Innovation has impact on processes of

production, product and the nature of the production system overall ◦  Impact on production process is measured by either

productivity or unit costs �  Productivity is a measure of what can be produced as output

from what is put into production as input (link output to inputs of a given factor of production)

�  The most common measure labor productivity output per unit of labor input

�  The appropriate measure of output in productivity should be real value of sales of a firm but preferable to use real value-added which is the result of subtracting from sales the real value of intermediate inputs, energy and materials

�  The growth in productivity will be the amount by which the growth rate in value-added exceeds that in employment

2

The impact of technological change �  Labor productivity may grow because of investment in new

capital enhances the capacity of labor to contribute to growing output ◦  Existing technology may be more efficient as a result of learning ◦  Improvements in the organization of production, technical

efficiency increases ◦  New production methods introduced either through purchasing

capital with new design or undertaking changes based on R&D undertaken within the industry ◦  So technological innovation which is driving productivity up

�  Finally, existing technology used at a given level of technical efficiency may contribute to raised productivity if operated on a larger scale (economies of scale)

�  Productivity may rise as a result of moving productive resources from relatively low return uses to higher return employment

3

The impact of technological change

� Total factor productivity can only be measured if some device is used to assign weights to each of the inputs used in production (relation between output and weighted inputs)

�  Two input world

�  The inputs are weighted by a and b, the shares of labor and capital where a+b=1

�  Technical relationship between inputs and output in production, the production function

4

The impact of technological change

� The common form of production function � By logarithmic differentiation with respect

to time yields an expression for the rate of change in TFP

5

The impact of technological change

�  If there are two inputs, TFP growth is equal to the rate of output growth minus the output share weighted contributions of labor and capital input growth

� TFP referred to as residual in explaining output growth rates

� The growth rate of labor productivity equals the sum of TFP growth and the growth in capital per unit of labor weighted by the capital’s output share

6

The impact of technological change

�  Impact on products ◦  The impact of innovation relates to qualitative

changes in the objects generated by production ◦  Structural innovations which arise if the

overall system and its component parts grow at different rates ◦ Material innovations which arise if the stuff

from which the system built is changes ◦  Systems innovations which arise when

different sets of design principles are combined to yield entirely new structural forms

7

Production, technological progress and the language of economics �  Technological progress is described as

exogenous if it occurs outside the economic system and hence independently of economic variables

�  It is endogenous if it occurs within the system and is hence subject to economic influences

�  Technological progress is said to be disembodied when it has the effect of raising the productivity of all machines of all ages

�  The progress is described as embodied if it enters the production process by being built into the design of new machines

8

The economic approach to production �  The production function shows which inputs and

how many units of each would be required making best use of existing technological knowledge to produce specified quantities of a output per period

�  If any input increases while all others constant, output will increase but that repeated additional (marginal) doses of any given input will at some point start to bring increasingly small additions to output if the remaining inputs are held constant

�  Mathematically, all first partial derivatives dQ(t)/dX(t) are positive but all second partial derivatives become negative

9

The economic approach to production �  Output generated by an additional unit of input is

called the marginal product of that input, production functions are assumed to be characterized by diminishing marginal product of all inputs

�  With two inputs, K and L and production function as isoquant

�  It represents all pairs of capital and labor required to produce a specific quantity of output (Q)

�  The slope of isoquant at any point (slope of tangent at that point) shows how much extra labor must be employed when one unit of capital is removed, marginal rate of technical substitution MRTS

�  It is the ratio dK(t)/dL(t) which must be negative

10

The economic approach to production

�  Its absolute value falls for movements down

the isoquant since dL(t) rises for equal reductions in K(t)

� Diminishing marginal rate of technical substitution and this captures the idea that inputs into production are not perfect substitutes for one another

11

The economic approach to production �  For any given level of output, particular ratios of

capital and labor represented by the slope of the ray to appoint on an isoquant may be described as techniques of production (ratio of K/L)

�  If only one technique, the isoquant shrinks to a single point representing a fixed coefficient technology where the coefficient is the unique capital/labor ratio

�  The production function for a given type of output is represented by the set of all isoquants relating to that output

�  The technology defines the shapes and positions of the isoquant

12

The economic approach to production �  From isoquant map we can derive total product curve

(TPC) �  The TPC is found by assuming that one input (capital) can

not be varied immediately in response to changed conditions �  To construct it, you read the output level and labor input

with capital fixed �  Then labor on horizontal and output on vertical draw TPC �  TPC has a positive but diminishing slope �  Since the slope of TPC shows by how much output rises

when labor input rises by a small amount, holding capital inputs constant, this reflects the property of diminishing marginal product for any input

13

The economic approach to production � Another important feature of the

production function is returns to scale ◦  If output rises by more than the given

multiple, there are IRS �  F(aK,aL)>aF(K,L) ◦  If output rises by less than the given multiple

for inputs, DRS �  F(aK,aL)<aF(K,L) ◦  If output rises by exactly the same multiple,

there are CRS �  F(aK,aL)=aF(K,L)

14

Representing technological change

15

Representing technological change �  Isoquant and production function should relate only

to technology which makes minimum use of inputs �  A technological change is an addition to the set of

ways in which production could be affected and can be represented as a point somewhere on the isoquant ◦  If the new blueprint is associated with a point to north

east of the existing unit isoquant, the new way of making a unit of output uses more inputs than other known methods (a point outside) ◦  If the new blueprint is associated with a point to south

east of the existing unit isoquant, the new way of making a unit of output uses fewer inputs than other known methods (a point inside)

16

Representing technological change �  Technological advance is represented by a shift in the

isoquant �  If technological change will affect input requirements

at all levels of output, then the whole isoquant map will shift towards origin

�  In terms of TPC, technological advance is represented by an upward shift of the curve, because producing given output with fewer inputs is equivalent to producing more output with the same quantity of inputs

�  The production function also underlies the analysis of cost that is influenced by technological progress

�  The choice of technique minimizes production costs given input prices

17

Representing technological change �  The isocost line showing all combinations of labor and

capital that can be bought for the same expenditure �  Total expenditure E, sum of total costs of capital and labor �  Isocost line

�  The slope of isocost line represents wage/rental rate ratio (-w/r) and is steeper the higher w is relative to r

�  Higher isocost lines represent higher levels of total expenditure

18

Representing technological change

19

Representing technological change �  For economic efficiency, the technique which

minimizes total expenditure has to be used, cost minimizing technique

�  The cost minimizing choice of inputs to produce output level, cost minimizing technique characterized by the ratio K*/ L* (when isoquant tangent to isocost)

�  Expenditure will be minimized when the point on the isoquant (technique) is found that touches the isocost line nearest to the origin

�  Technological progress that shifts the isoquant towards the origin will enable the same amount of output to be produced on a lower isocost line.

�  Technological progress thus leads to cost reductions

20