Research and Development Part 1: Innovations and Patents

n Economic growth is caused primarily by technological progress (the Solow model of growth). n R&D is the “engine of technological change”. n Firms become industry leaders by conducting R&D that leads to innovations in products and processes.

n Schumpeter coined the phrase “creative destruction” to refer to the capitalist system. n Periodically, new products and processes are developed which destroy the market power of old products and processes.

What is R&D? n Basic Research: Does not lead directly to new product or process, but improves “fundamental knowledge”. n Applied Research: Involves substantial engineering input and results in new product or process. n Development: Move product/process to consumer market/mass production.

What is R&D, con’t n Process innovations: better method for producing existing product. n Product innovations: new product. n Drastic innovation: dramatically reduce costs to extent that innovator essentially becomes a monopolist. n Non-drastic or gradual innovation: improves firm’s competitive position, but there still is competition.

A “Drastic” Innovation New MC MR $ Quantity D MC for industry PCPC QCQC PMPM QMQM

A “Non-Drastic” Innovation New MC MR $ Quantity D MC for industry PCPC QCQC PMPM QMQM

R&D and Market Structure n What market structures are most conducive to R&D? n Early View (Schumpeterian Hypothesis): u R&D generally conducted by large firms. u R&D generally conducted in industries with market power. u Thus, markets with large firms and market power not necessarily bad as this would encourage R&D and innovation.

Market Structure and the Incentive to Innovate n Is the Schumpeterian Hypothesis correct? Are incentives for R&D affected by market structure? n Start with a basic inverse demand curve: P= A-BQ. n We want to consider an innovation that could increase social welfare and then see whether market structure affects whether such an innovation will occur.

Arrow Model of Mkt. Structure & Innovation n Assume that the innovation would cost K to research and develop. n The result of the innovation is an improvement in the production process so that the constant marginal cost of production drops from c 0 to c 1. n Compare expenditure, K, to potential increase in surplus from change in MC, (appropriately discounted to account for increased surplus in the future as well).

The Welfare Effects of an Innovation C1C1 $ Quantity D C0C0  CS

Arrow Model, con’t n In a competitive market, a firm will only innovate if the cost of innovation is less than the increased profit as a result of the innovation. n Consider a perfectly competitive market. u If the innovation could be adopted by other competitors, there would be no increase in profit. All firms would adopt, but because of perfect competition, price would drop to equal the new lower cost.

Arrow Model, con’t n If the market is perfectly competitive but the innovation is not adoptable, the firm will be able to make profit as a result of the innovation. n The firm can undercut the competitive price by a couple of cents and supply essentially the entire market.

Increase in Profit in a Competitive Market from a Non-Adoptable Innovation C1C1 $ Quantity D C0C0 Innovator’s price Increase in Profit Note that the increase in profit is less than the increase in potential welfare

Increase in Profit in a Monopoly from Innovation C1C1 $ Quantity D C0C0 Innovator’s price Note that the increase in profit for the monopolist (the area of the blue box minus the area of the yellow box) is less than the increase in profit for the firm in a competitive market. MR

Arrow Model, con’t n A monopolist will actually value the innovation less than a competitive firm. u The monopolist was already making profit, already had some market power. This is known as the replacement effect. n Even with more complex models, general result is that the more competitive the market, the more gains to an innovator. n In all cases, firms undervalue innovation compared to effect on total surplus.

Arrow Model, con’t n Is the Schumpeterian Hypothesis wrong? Are gains from innovation inversely related to market power? n Market power pre-innovation makes the post-innovation gain smaller. n But we assumed that post-innovation the market would be a monopoly, regardless of the pre-innovation structure. n Also, we said nothing about the market for innovation itself.

Another Model of Mkt. Structure & Innovation n Suppose that there are two potential innovators, an incumbent monopolist with technology c 0 and a potential entrant. n Assume the innovation is non-adoptable, so that the first firm to innovate can lower marginal costs to c 1 at a cost of K. n If the potential entrant innovates first, he becomes the low-cost firm in a duopoly. His return to innovation is  D (c 1,c 0 ) - K.

Another Model of Mkt. Structure & Innovation n If the monopolist is the first innovator, he will retain his monopoly and earn profits of  M (c 1 ) - K. n If the monopolist does not innovate, the PE will, so the monopolist will get  D (c 0,c 1 ). n Thus the return to innovation for the monopolist is  M (c 1 )-  D (c 0,c 1 ) - K. n For the PE, the return is  D (c 1,c 0 ) - K.

Another Model of Mkt. Structure & Innovation n As long as  M (c 1 )-  D (c 0,c 1 ) - K >  D (c 1,c 0 ) - K the return to innovation is greater for the monopolist than for the PE. n Rewrite this condition:  M (c 1 ) >  D (c 1,c 0 ) +  D (c 0,c 1 ). n Which says that if the profit to a monopolist is greater than the joint profit of duopolists, the gain to innovation is greater for a monopolist. And it is. n This is known as the efficiency effect.

Schumpeter Revisited n Is the Schumpeterian Hypothesis wrong? n It depends on the nature of competition. n If the firm starts with market power, the increase in market power due to an innovation will not be as large as if the firm started without market power. n However, firms with market power have greater incentives to innovate to protect their existing market power.

Even More Evidence: the Dasgupta/Stiglitz Model n Consider a slightly more sophisticated model where all firms in the industry can innovate simultaneously. n Assume firms compete through quantity. n  i = P(Q)q i - c(x i )q i - x i where x is the firms expenditure on R&D. n If all firms spend the same amount, x*, on R&D, all firms have the same cost c(x*). n Solve just as we would any n-firm Cournot model.

Dasgupta/Stiglitz con’t n We then get the following expression of the equilibrium quantity for each firm in this market: q* = (a-c(x*))/(b(n+1)). n To determine the optimal level of R&D, take the derivative of profit w.r.t. x i and set equal to 0. n  i = P(Q)q i - c(x i )q i *- x i, so the derivative is: -(dc(x i )/dx i )q i * - 1 = 0.

Dasgupta/Stiglitz con’t n What does -(dc(x i )/dx i )q i * - 1 = 0 mean? n Remember that dc(x i )/dx i is the decrease in marginal cost due to an additional dollar spent on R&D. So the first term is the total benefit of an additional dollar spent on R&D. n In equilibrium, this total benefit must be equal to the cost of the additional R&D, i.e. $1.

Dasgupta/Stiglitz con’t n But the important thing to note is that the marginal benefit -(dc(x i )/dx i )q i *, depends on q*. n And q* depends on the number of firms in the industry: q* = (a-c(x*))/(b(n+1)). n The more firms, the lower is q* and thus the lower the benefit from R&D. n A lower benefit means less R&D spending, so the more firms in the industry, the less spending by each firm on R&D.

Dasgupta/Stiglitz con’t n How will total industry spending, nx*, be affected by concentration? n Total spending may increase or decrease as industry size increases, depending on the elasticity of demand in the industry. n However, in most cases, increasing the number of firms leads to less industry spending.

R&D and Market Power n How do we balance the potential positive aspects of market power (w.r.t. R&D and innovation) with the positive aspects of less concentrated markets (w.r.t. efficiency)? n Key is to recognize the dynamic aspect of the process. We want to increase efficiency over time which may require a settling for less efficiency in the short run.

Public Policy w.r.t. R&D n What policies best encourage the discovery of new products and processes? n What policies best encourage dissemination of new ideas and technologies?

Patents and Copyright n Patents and copyright confer property rights to new inventions, new designs, and new creative works. n The property rights allow the innovator to exert monopoly power, which acts as an incentive to encourage R&D and innovation. n However, to achieve the efficiency gains from the innovation, it must be used widely, so the property rights must be terminated at some point.

Effect of Patent on Surplus $ Quantity DMR This surplus goes to producer over length of patent, then transfers to consumers (B) This surplus goes to consumers when patent expires (C) This surplus goes to consumers (A) Q P Q C

What is the optimal patent length? n If T is the length of the patent, then the producer gets B (from the graph) for T years-appropriately discounted of course. n The consumers get the A each year, plus the B and C for all years after T. n Note that after T years, B just transfers from the producer to the consumer. n Real gain in surplus is C, which we get after the patent expires.

What is the optimal patent length, con’t n The shorter T, the sooner we get C. n However, the producer decides whether to innovate based on the increased profit, i.e. how long he gets the surplus in B. n The longer T, the more incentive to innovate and the bigger are A, B, and C. n Optimal patent length balances these two effects.

Optimal Breadth of Patents n Breadth is the amount by which innovation must differ from an existing product or process. n The more broad a patent is, the harder it is to “invent around” the patent and thus the more profit the producer can get. n Related to optimal length -- i.e. could have “short and fat” patents or “long and thin”.