ECON 330 Lecture 23 Monday, December 16

Last week Wednesday There was a lot of snow, very few people could make it to the lecture. We had a short lecture on entry deterrence and predatory pricing – If you missed the class, read the lecture notes, do the in-class activity.

Today’s menu Innovation and research and development (R&D) (ARGE, in Turkish)

This Wednesday, Dec 18: COURSE EVALUATIONS Very important day: Please come to class

Research and Development

R&D is the “engine of technological change” Economic growth is caused primarily by technological progress. Firms can become industry leaders by successful R&D that leads to innovations in products and processes. Firms may lose their markets if new products and processes are developed by entrants.

Schumpeter’s “creative destruction” [I]n capitalist reality as distinguished from its textbook picture, it is not [textbook] … competition which counts but … the competition from the new commodity, the new technology, the new source of supply, the new type of organization (…) –competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but … at their foundations and their very lives.

The R&D expenditures, selected large companies (from the textboook)

The R&D expenditures, selected large companies (from The Economist) 2010 and 2011 The R&D expenditures, selected large companies (from The Economist)

The central question(s) What is the relation between market structure and R&D? First question: How does market structure affect the level of R&D? STRUCTURE  R&D Second question: How does R&D influence the evolution of market structure? R&D  STRUCTURE

Question #1 What market structure is most conducive to innovation: monopoly or perfect competition? Two views: Joseph Schumpeter: Firms with market power (monopolies) innovate more. Kenneth Arrow: Competitive pressure makes firms do more R&D.

Kenneth Arrow won the Nobel Prize in Economics in 1972 Kenneth Arrow won the Nobel Prize in Economics in 1972. To date, he is the youngest person to have received this award, at 51.

Empirical evidence: What does the data say? Who is right?

Research findings There is a huge amount of research on how market structure affects R&D. The effect of industry concentration (market structure) on innovation activity is relatively weak. There is evidence for some association between firm size and innovation a U-shaped relation between competition and innovation

Market concentration, (C4) The famous graph R&D expenditure as percentage of sales 0 100 Market concentration, (C4)

R&D activity and firm size link Likelihood of undertaking R&D greater the larger a firm R&D expenditures increase monotonically and typically proportionately with firm size among R&D performers within industries Number of innovations increases less than proportionately with firm size R&D productivity declines with firm size

Now the second question…

Question #2 How do the dynamics of R&D effect the market structure? Possibility 1: Market leaders increase their lead and monopolists persist as such Possibility 2: New firms constantly replace incumbents.

How does the market structure influence the R&D activity? Arrow versus Schumpeter

Market Structure and Incentives for R&D Consider an innovation that lowers the MC from cH to cL. This is called a “process innovation”.

Some definitions Process innovation a better (lower cost) method for producing existing products. Product innovation new product. Drastic innovation big reduction in cost so that the innovator becomes a monopolist. Non-drastic or gradual innovation improves firm’s competitive position, but there still is competition.

Market Structure and Incentives for R&D A process innovation that lowers the MC from cH to cL. What is the value of this innovation to the monopolist?

Value of innovation to the monopolist Approximately qMx(cH–cL) cH cL

Lets see… Is this a good approximation Lets see… Is this a good approximation? Use some numbers: Demand: P = 120 –Q. cH = 80 to cL = 60.

With Innovation Profit is A Net Profit Gain is Area A – Area C Initial Profit is C With Innovation Profit is A Net Profit Gain is Area A – Area C $/unit 120 Approximation qMx(cH-cL) 20x20 = 400 100 90 C A 80 60 C = 20x20 = 400 A = 30x30 = 900 A-C = 500 Demand MR Quantity 20 30 60 120

Market Structure and Incentives for R&D For a monopolist, the value of a process innovation that lowers the MC from cH to cL is qMx(cH – cL). Area A in the graph.

Now… Suppose the market is competitive with many firms with constant MC = AC = cH. One of those firms innovates and reduce its cost to cL. What is the value to the innovating firm?

Let’s see this using the numerical example Demand P = 120 – Q Let’s see this using the numerical example Demand P = 120 – Q. cH = 80 cL = 60

Profits after innovation is Area A P = 120 – Q; MC= $80. With MC = 80, the equilibrium Q is 40. Innovator lowers cost to $60 and can sell all 40 units at P = $80. Profit Gain is $800 Initial profit is 0 Profits after innovation is Area A $/unit 120 80 A 60 Quantity 40 60 120

If one of the competitive firms innovates and reduce its cost to cL, it will set price (slightly) below cH. Value to innovating firm is (cH–cL)qC. Area A + B in the graph.

Summary Kenneth Arrow, 1962, “The Economic Implications of Learning by Doing” The competitive firm has a greater incentive (A+B) to innovate than a monopoly firm (A). Arrow’s argument is that competitive markets give stronger incentives to firms to innovate.

Research shows: Innovation activity seems to increase with firm size R&D projects are risky and require large fixed costs Large firms have better access to finance or can use own profits to finance R&D are in better position to exploit unforeseen innovations. can spread risk involved in R&D by undertaking many projects at the same time can more easily appropriate the returns from innovation

Incentives vs. capacity for innovation (R&D) Way can’t small firms borrow to finance their R&D projects? Capital markets are not perfect (especially for R&D financing) Consider a venture capitalist (VC) negotiating with a small firm that has an R&D project. To convince the VC the firm must explain the idea. Once the idea is explained the VC can use it itself.

Incentives vs. capacity for innovation The incentives for R&D are stronger in competitive industries (Arrow’s theory) but Large firms have the capacity to do R&D (financial, organizational, legal, etc.) (Schumpeter’s theory)

In-class learning activity Cournot duopoly v Monopoly

The Inverse demand: p = 20 – Q. The firms’ cost function is TC(q) = cq The Inverse demand: p = 20 – Q. The firms’ cost function is TC(q) = cq. R&D reduces the marginal cost from c = 3 to c = 2. Monopoly profits: πM = (20–c)2/4 Cournot duopoly: Nash equilibrium profits: πA = (20–2cA+cB)2/9; πB = (20–2cB+cA)2/9 cA 3 2 1 cB profit A 32 40 49 profit B 28 25 profit monopoly 72.25 81 90.25