Lecture 9.2: R&D and Innovation

Industrial Organization

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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?

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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

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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