OT Steady R&D by Industry Leaders and Innovative R&D by Industry Followers Joint work with Yasuhiro Arai

OT Steady R&D by Industry Leaders and Innovative R&D by Industry Followers (1) When small firms fight back against large firms in R&D activities (2010, BE Journal of Economic Analysis & Policy, joint work with Noriaki Matsushima) (2) Market Competition, R&D, and Firm Profits in Asymmetric Oligopoly (2011, Journal of Industrial Economics, joint work with Junichiro Ishida and Noriaki Matsushima) (3) Steady R&D by Industry Leaders and Innovative R&D by Industry, joint work with Yasuhiro Arai

OT Plan of the Presentation (1) Rough sketches of the model and results (2) Two related my own previous papers (a) A story of major firms’ innovation (b) A story of minor firms’ innovation (3) Innovation size and the model of patent race (4) Model formulation (5) Results, intuition, and implications (6) Alternative model formulations and the robustness of our results

OT Rough sketch of the model (1) A vertically differentiated product market with full market coverage, Bertrand competition, duopoly. (2) There are three possible players engaging in quality-improving R&D, the current industry leader (providing a higher quality product), the current industry follower (providing a lower quality product), and the outside inventor (engaging in R&D only). (3) Innovation size or R&D expenditure for quality improving is chosen.

OT Results (1) The current industry follower (outside inventor) chooses larger innovation size (targeting a larger size of quality improvement) and smaller R&D expenditure than the current industry leader. In our model, the current industry leader is a larger firm in terms of both market share and profits. ~The major firm spends larger money for the project with smaller innovation size. (2) Innovation competition increases the innovation size and decreases R&D expenditure of the current industry follower.

OT Results (3) The effect of Innovation competition on the innovation size and R&D expenditure of the current industry leader is ambiguous, but under moderate conditions, the effects are opposite to those of the industry follower. (4) The technology of outside inventor should be purchased by the industry follower, but it is purchased by the industry leader in equilibrium. (5) The industry follower spends smaller money for a larger innovation size than the industry leader in cost- reducing R&D investment, too.

OT Background Many empirical works suggested that major firms (larger firms) engage in more intensive R&D than minor firms. However, minor firms often succeed in outstanding innovations (Cohen and Klepper, 1996; Rogers, 2004) and some of them became major firms. Many theoretical works suggested that major firms more likely spend larger money than the minor firms (Lahiri and Ono 1999, Ishida et al, 2010) The opposite result ~ Matsumura and Matsushima (2010)

OT The model of Ishida et al (2011) one efficient firm (firm 1), n-1 inefficient firms (n ≧ 2), quantity-setting competition At the first stage, firms engage in cost-reducing R&D. At the second stage, firms face Cournot competition.

OT Results (1) The efficient firm’s profit can be increasing in n, whereas less efficient firm’s is always decreasing in n. (2) R&D of the efficient firm can be increasing in n, whereas less efficient firm’s is always decreasing in n. (3) HHI can be increasing in n. Nevertheless it improves welfare. Competition makes the major firm be stronger and be more innovative, while it makes the minor firms be weaker and be less innovative.

OT Intentional Increase of Competitors by Large Firms Electric Power Industry →TEPCO supports small PPS Natural Gas Distribution →Tokyo Gas and Osaka Gas support small gas distribution companies Automobile→Toyota helps small firms through financial and technological supports Steal Industry→Nippon Steal supports Sumitomo and Kobe Nisshin gave up its fundamental patent and as a result it induced the entries of rivals. (Creating a market)

OT Two Views on Competition and R&D Monopoly View ~ Monopoly stimulates innovation ・ R&D investments are financed from monopoly profits ・ Monopolists internalize the spillover effects of R&D ・ R&D has economy of the scale Competition View ~ Competition stimulates innovation ・ Replacement effect (Arrow,1950) ・ Competitive pressure disciplines the management Our result: competition can increase R&D by major firms and reduces R&D by minor firms.

OT Matsumura and Matsushima (2010) Hotelling Model, Location-Price, Duopoly (Lower cost firm and higher cost firm) (1) Cost-reducing R&D, (2) Location Choice, (3) Bertrand Competition

OT Matsumura and Matsushima (2010) Helping a minor firm (higher-cost firm) can reduce consumer surplus and total social surplus. A minor firm may engage in more aggressive R&D investment than a major firm. The minor firm engages in intensive R&D so as to distort the product positioning of the major firm ~ The major firm choose a lesser degree of product differentiation when the cost difference between firms is large, while the minor firm always prefers maximal differentiation.

OT Our Two Works Ishida et al (2010) explained the fact that major firms often spend larger money for R&D. Matsumura and Matsushima (2010) explained the fact that minor firms can be more aggressive for innovation. However, I now think that my research strategy might not be appropriate, take a wrong course.

OT Major Firms vs Minor Firms Revisited Minor firms often succeed in outstanding innovations →It does not imply that minor firms often spend larger money. Minor firms may target more significant (drastic) innovations with small money →substantial innovation in minor firms takes place, with lower probability of success. We should consider innovation size as well as R&D expenditure.

OT Patent Race O'donoghue (1998, RAND) O'donoghue (1998, RAND) Firms choose both innovation size and R&D expenditure →Innovation size is efficient, while R&D expenditure is too small for social welfare. The innovation size of the firm affects the rivals' R&D expenditure ⇒ An increase of the innovation size of one firm stimulates the rivals R&D expenditure and improves welfare.

OT Patent Race among Heterogeneous Players Ishibashi and Matsumura (2006, EER) A public research institute competes against private firms. ⇒ An increase of the innovation size of the public research institute and a decrease of the budget from stand alone welfare maximizing level stimulate the private firms' R&D and improve welfare.

OT Paper presented today We examine whether the major firm or the minor firm chooses a larger innovation size. In our model, the major firm is the firm which has the advanced technology and supply a higher quality product.

OT Notations q i : quality of firm i's product, δ≡|q 1 -q 2 | q i : initial quality of firm i's product θ: marginal willingness to pay for quality Δ i : Innovation size of firm i I i : R&D expenditure of firm i P: Probability of success of innovation π i : Firm i's profit, W: social surplus, Superscript E: Equilibrium value. Superscript S: Second best value. Superscript G: Equilibrium outcome when firms 1 and 2 take their actions.

OT The Models Three candidates of innovators. Firm 0: Outside Inventor Firm 1: Current Industry Leader Firm 2: Current Industry Follower Three Models Only firm 0 engages in R&D, only firm 1 engages in R&D, and only firm 2 engages in R&D.

OT Vertically Differentiated Market We use a model formulated by Gabszewitz and Thisse (1980) and Shaked and Sutton (1983). Product market ~ Firm 1 and Firm 2 compete. Zero production cost, Bertrand competition Each consumer purchases one unit product from firm 1 or firm 2. The utility of consumer is θq- price of the product, θ~ Uniformly distributed on the interval, full-covered (minimal θ is large enough) →Leader's profit=αδ, Follower's profit=βδ, α>β

OT Innovation size choice When firm 1 succeeds, q 1 = q 1 +Δ 1 Firm 1 succeeds with probability P(Δ 1 ). It is decreasing and concave. When firm 2 succeeds, q 2 = q 1 +Δ 2 Firm 1 succeeds with probability P(Δ 2 ). It is decreasing and concave. When firm 0 succeeds, it sells the technology by auction

OT Who purchases the technology from the outside inventor The willingness to pay of the current industry leader is larger than that of the current industry follower. →Firm 1 purchases the technology from the outside inventor (Proposition 3(ii)). ~The resulting quality difference between two firms is larger when firm 1 purchases it than when firm 2 purchases it. However, firm 2 should purchase the technology by firm 2 for social welfare (Proposition 3(i)) ~The resulting average quality is higher when firm 2 purchases it than when firm 1 purchases it, both are consumer- benefiting and welfare-improving.

OT Implications of Proposition 3 Major firms such as Google and Microsoft often purchase innovation-oriented small firms and obtain advanced technologies. However, it can be welfare-reducing.

OT Comparison of Innovation Size among Three Players Δ 0 E > Δ 2 E > Δ 1 E (Proposition 5). The current industry follower and outside inventor choose the larger innovation size than the current industry leader. The current industry leader obtains the largest profits by the success of innovation. →It has a stronger incentive to reduce the probability of failure. The current industry follower obtains the smaller profits when it succeeds since the resulting quality difference is smaller.→ It has a weaker incentive to reduce the probability of failure.

OT Welfare Implications of Innovation Size Δ 0 E > Δ 0 S (Proposition 4), Δ 2 E > Δ 2 S (Proposition 2), Δ 1 E = Δ 1 S (Proposition 1) The expected private gain of firm 1's innovation is const (P(P The expected private gain of firm 1's innovation is const (PΔ 1 ). The expected social gain is const' (PΔ 1 ). Although const'> const, the solution of maximizing the former is exactly the same as that of the latter. This yields Proposition 1. Since the outside inventor and the industry follower have stronger incentives to enlarge Δ than the industry leader, Δ becomes too large for welfare.

OT R&D Expenditure Choice When firm 1 succeeds, q 1 = q 1 +Δ 1 Firm 1 succeeds with probability P(I 1 ). It is increasing and convex. When firm 2 succeeds, q 2 = q 1 +Δ 2 Firm 1 succeeds with probability P(I 2 ). It is increasing and convex. When firm 0 succeeds, it sells the technology by auction.

OT Results of R&D Expenditure I 0 E < I 2 E < I 1 E (Proposition 6(ii)), I 0 E < I 0 S, I 2 E < I 2 S, I 1 E < I 1 S (Proposition 6(i)), The current industry follower and outside inventor choose smaller R&D expenditure than the current industry leader. The expenditure is too small for social welfare.

OT Innovation Competition We consider the situation where both firm 1 and firm 2 engage in R&D. When only firm 1 succeeds, q 1 = q 1 +Δ 1, q 2 = q 2 When only firm 2 succeeds, q 1 = q 1, q 2 = q 1 +Δ 2 When both firms fail, q 1 = q 1, q 2 = q 2 When both firm succeed, either q 1 = q 1 +Δ 1, q 2 = q 2 or q 1 = q 1, q 2 = q 1 +Δ 2, with equal probability.

OT Effects of Competition Δ 1 G < Δ 1 E under moderate conditions (Proposition 7(i)), Δ 2 G >Δ 2 E (Proposition 8(ii)), I 1 G > I 1 E under further moderate conditions (Proposition 8(i)), I 0 G < I 0 E (Proposition 8(ii)) Competition accelerates the difference of behavior between the current industry leader and the follower. Competition reduces the value of success of R&D by firm 2, while it can increase the value of success of R&D by firm 1 since it prevents the position change (change of the role of the industry leader).

OT Alternative Model When firm 2 succeeds, q 2 = q 1 +Δ 2 →When firm 2 succeeds, q 2 = q 2 +Δ 2 All propositions except for proposition 3(i) hold. ~Firm 1 (not firm 2) should purchase the technology from the outside inventor for social welfare, and firm 1 purchases it in equilibrium.

OT Cost-Reducing R&D Firm 1: Current Industry Leader Firm 2: Current Industry Follower Marginal cost, c, is positive. Initially marginal costs are common between two firms and a firm engages in cost-reducing R&D. Results: The current industry leader chooses smaller innovation size and larger R&D expenditure than the current industry follower. ~A decrease of c yields a higher profit in firm 1 than in firm 2, so firm 1 has a stronger incentive to avoid the failure of R&D.

OT Summary (1) Major firms more likely engage in smaller size of innovation with larger money than minor firms. This result holds under various model formulations. (2) Innovation competition strengthens this tendency. (3) Innovation size by minor firms can be too large for social welfare. (4) Major firms more likely purchase the technology of outside inventors, but it can be harmful for social welfare.