ECON 330 Lecture 24 Wednesday, December 18

R&D and market structure … and course evaluations

What is the relation between market structure and R&D? The central question What is the relation between market structure and R&D?

Last lecture – A short summary On Monday: How does market structure affect the level of R&D? Kenneth Arrow: A competitive firm gains more from a cost reducing innovation than a monopoly.

Incentives vs. capacity for innovation The incentives for R&D are stronger in competitive industries, but … large firms have the capacity to conduct (and benefit from) R&D (financial, organizational, legal, etc.)

Today’s lecture What is the effect of R&D on market structure? More specifically, we will ask…

Does R&D contribute to a process of increasing dominance? Possibility 1: Market leaders increase their lead and become even stronger monopolies Possibility 2: New firms with better products/technology replace existing monopolies/oligopolies This is Schumpeter’s “creative destruction”, also known as “leapfrogging”

Soren Kaplan Leapfrogging is about changing the game - creating or doing something radically new or different that produces a significant leap forward!

A simple model

The dynamics of R&D competition The players: The Incumbent, (remains a monopoly if there is no new entry ) The (potential) Entrant, and … The R&D Lab. The R&D Lab has already discovered and patented a cost reducing innovation. The R&D Lab will sell the patent rights to the highest bidder.

Question: Which firm will bid more?

This bidding process on the patent rights is our short cut for modeling (thinking about) the R&D competition between the firms. This is a race for innovation, the first firm that innovates patents the technology so that the second firm can’t develop it. We assume that the firm that is willing to pay more for the innovation will win the R&D race (with probability 1, with certainty).

So, how much will a firm bid for the innovation? The rule: The maximum a firm will bid (pay up) for an innovation is … the difference in its profit between getting and not getting the innovation. profit with the innovation profit without the innovation

A short digression: Patents A patent provides the inventor with exclusive rights to a new and useful product, process, substance, or design.

The patent holder has the right to exclude others from making, using, selling, offering for sale, or importing the patented invention.

The patent holder must disclose the invention as part of a publicly available patent document.

Intellectual property rights in the US constitution The US (and English) law has two categories of protectable creations: Writings and Discoveries Copyright law for writings, Patent law for inventions. Copyright: the author’s life plus fifty years Patents : seventeen years

Patents application: three legal requirements 1. Novelty The technology must not be identical to an existing invention. 2. Non-Obviousness (Inventive step) The technology must be different enough (from the prior art) so as not to be obvious (in view of the prior art). 3. Usefulness (Industrial applicability) The invention must have a useful purpose.

United States Patent no. 5,255,452 Method and means for creating anti-gravity illusion From George Symeonidis, Lecture notes for EC261: MANAGEMENT OF NEW TECHNOLOGY

United States Patent no. 5,255,452 October 26, 1993 Method and means for creating anti-gravity illusion Abstract A system for allowing a shoe wearer to lean forwardly beyond his center of gravity by virtue of wearing a specially designed pair of shoes which will engage with a hitch member movably projectable through a stage surface. The shoes have a specially designed heel slot which can be detachably engaged with the hitch member by simply sliding the shoe wearer's foot forward, thereby engaging with the hitch member. Inventors: Jackson; Michael J. (Los Angeles, CA) Bush; Michael L. (Hollywood, CA) Tompkins; Dennis (Hollywood, CA) Assignee: Triumph International, Inc. (Los Angeles, CA) Appl. No.: 07/905,479 Filed: June 29, 1992

R&D race and the evolution of market structure Back to the model

The model: R&D race There are… one incumbent and one potential entrant, and… the R&D lab, that has already discovered and patented a (cost reducing) innovation. The innovation will be sold to the highest bidder.

The assumptions The entrant enters only if she gets the new technology. If … the entrant acquires the patent, it enters the market. The market becomes a duopoly, Each firm earns πD. the Incumbent acquires the patent: He remains a monopoly, and earns πM. The entrant earns 0.

Who has a stronger incentive to innovate? We start with the Incumbent (currently a monopoly)

Who has a stronger incentive to innovate? Suppose the Incumbent (current monopoly) acquires the patent: profits: πM If not … Then this means that the entrant has won, so there is entry… Incumbent’s profits: πD The monopoly’s maximum bid is πM – πD

What about the entrant? The entrant acquires the patent and enters profits: πD If not, it stays out and earns 0 profits (this is by assumption) The entrant’s maximum bid is πD

Whose bid is higher? Who wins the R&D race? The monopoly will pay more for the innovation if πM – πD > πD. Rewrite this as πM > 2πD.

The condition πM > 2πD This inequality is always true: The maximum profit in any market is the monopoly profit! So, the incumbent’s incentive to innovate is always greater than the entrant. Intuition: Entry means competition … The loss in the incumbent’s profit is always larger than the entrant’s profit from entry.

Unless … After entry the two firms collude and charge the monopoly price (using repeated interaction and grim-trigger strategies).

“Sleeping patents” (Gilbert and Newbery, 1982) What is this?

Monopoly and Sleeping Patents 8/2/2018 Monopoly and Sleeping Patents A sleeping patent is a patent that is not being used. Why would firms spend money on patents they don’t plan to use? So that potential entrants cannot use the technology!

Before we move on to more complicated stuff, let’s do the course evaluations.

Course/Instructor evaluation surveys

Course evaluations 22582 22583 ECON 330 Lec1 Murat Usman Fall 2012 MGEC 330 Lec1 Murat Usman Fall 2012 22583

Here comes the more complicated stuff.

32 variations on the basic theme Variation I: With probability ρ the entrant will not bid.

With probability ρ the entrant will not bid. If no firm bids, the patent will remain unused. The market will remain a monopoly.

Who bids more? We start with the Incumbent The Incumbent acquires the patent: ( entry is avoided) profits: πM If it doesn’t bid, then the entrant may (or may not) bid and win The Entrant will bid with probability 1–ρ! Incumbent’s expected profits: ρπM + (1–ρ)πD. The maximum bid is πM – [ρπM + (1–ρ)πD] = (1–ρ)(πM – πD)

What about the entrant? The entrant acquires the patent and enters. The market becomes a duopoly Entrant’s profits: πD If it doesn’t bid: profits: 0 The entrant’s maximum bid is πD

Who wins? The entrant wins if πD > (1–ρ)(πM – πD).

The inequality may or may not hold! It will hold… πD > (1–ρ)(πM – πD). The inequality may or may not hold! It will hold… if there is sufficient uncertainty about the presence of a rival, if πD is not very small! Then the monopolist will pay less for the innovation than the entrant and the market will evolve into a duopoly.

Patent race and market structure: Cournot competition In-class learning exercise

Current technology has TC(q) = 3q Current technology has TC(q) = 3q. The R&D Lab has developed a new technology that reduces the cost from c = 3 to c = 2. The Entrant must acquire the new technology to enter. The incumbent monopoly assumes that with probability ρ the entrant will not bid for the new technology. Compute the lowest value for ρ for which the entrant wins the R&D race, so that the market becomes a duopoly.

Profits in the Nash equilibrium (Cournot competition): [ cA is Firm A’s MC, cB is Firm B’s MC.] πA = (20–2cA+cB)2/9; πB = (20–2cB+cA)2/9 Monopoly profits: πM = (20–c)2/4 cA 3 2 cB profit A 32 40 profit B 28 c 3 2 profit 72.25 81

Help: What is the maximum the INCUMBENT will pay? For the incumbent compute What is the maximum the ENTRANT will pay? For the entrant compute

Solutions The Incumbent: Win the R&D race: profits = 81 Don’t win the R&D race profits = ρ72.25 + (1 –ρ)28 Max bid is 81 – [ρ72.25 + (1 –ρ)28] The Entrant: Win the R&D race: profits = 40 Don’t win the R&D race profits = 0 Max bid is 40 The entrant wins the R&D race if 40 > 81 – [ρ72.25 + (1 –ρ)28]. Solve this for ρ: The entrant wins the R&D race if ρ > 0.29

End of lecture