2. Technology, Research and Development, and Efficiency Please listen to the audio as you work through the slides.

3. Part 3 Topics Focus will be on the Slow Growth / No Growth Economy Technology, R & D, and Efficiency The Demand for Resources Antitrust Policy and Regulation Income Inequality and Poverty

4. Technology, R&D, and Efficiency: The Microeconomics of Technological Advance in a Slow Growth / No Growth world Learning Objectives: 1.The three-step process of technological advance. 2.How a firm determines its optimal level of R&D spending. 3.How Innovation can increase a firm’s profits. 4.Why and how a firm would use the fast second strategy to increase it’s economic profit 5.How firms can use the protection provided by patents, copyrights, and trademarks to increase their economic profits. 6.How firms can use their Brand to increase their economic profits. 7.How technological advance increases productive efficiency and allocative efficiency.

5. Our Slow Growth / No Growth Future The Depression of the 1930’s lasted 11 years We are 6 years into the great recession Growth since 2009 driven by: – Stimulus programs – Bailouts – Expansionary Monetary Policy – Not sustainable

6. A Few Key Characteristics: Rising fossil fuel based energy “costs” Tight credit markets – low interest rates but low Investment spending Rising public and private debt Population increase Growing income and wealth inequality Our Slow Growth / No Growth Future

7. Consider Impacts on key Technological Advance drivers – Invention – Innovation – Diffusion – Research and Development Spending – Economic efficiency Our Slow Growth / No Growth Future

8. A few past successes 1968 Nike – now >$10 billion in sales 1967 Intel – now worlds largest producer of microprocessors 1962 Wal-Mart – now annual revenues > $300 Billion Their keys to success: Technological Advance New and better goods and services or new and better ways of producing or distributing them.

9. Technology, R & D, and Efficiency The pursuit of technological advance is a major competitive action among firms. Impact of Slow Growth /No Growth?

10. Technological advance Three step process of technological advance 1. Invention The discovery of a product or process through the use of imagination, ingenious thinking, and experimentation and the first proof that it will work.

11. Technological advance A Process - Inventing

12. Technological advance A result – an invention

13. Alexander Graham Bell with Prototype Telephone

14. Aptera announces 200 MPG prototype car

15. Invention Usually based on scientific knowledge and is the product of individuals, either working on their own or as members of an organization - R&D staff. Impact of reduced spending on education? Impact of reduced access to credit?

16. 2.Innovation: The introduction of something new Draws directly on invention (the discovery and first proof of workability). Cannot be patented. Two types: Product innovation – new and improved products or services ( Cosmetics, Food, Cars, Redbox, Kodak) Technological advance

17. Innovation can be: the first successful commercial introduction of a new product

18. 2. Innovation Two types: Process innovation – new and improved methods of production or distribution (printing, assembly, distribution, power generation) Technological advance

19. Innovation can be: the first use of a new method,

20. New Processes

21. Innovation can be: the creation of a new form of business enterprise or process.

22. 3. Diffusion The spread of an innovation through imitation or copying. New and existing companies emulate successful innovations of others. Unlimited Mileage - Alamo car rental PDA and Smart Phones - 1996 Palm Pilot Innovation led eventually to widespread imitation. Technological advance

24. University and government scientific research Basic scientific research – University based Cannot be patented, no immediate commercial use Entrepreneurs study output from university and government labs Past Breakthroughs Hybrid seed corn Satellite communications Computer mouse Sharing in potential profit BP and UC Berkley - $500 million energy research consortium Some firms conduct their own basic research Pharmaceutical industry More on R and D Funding

25. Role of Entrepreneurs of the past A few famous Entrepreneurs – Andrew Carnegie – steel – Henry Ford – automobiles – Levi Strauss – blue jeans Characteristics of their era: Abundant energy sources and credit How successful would they be in this SG/NG era?

26. Entrepreneurs working together Entrepreneurs in groups – Teams – in same company or a group of companies – Groups of entrepreneurs from different companies Trans Alaska Pipeline System – Alyeska Pipeline Service Company, the company that built the Trans Alaska Pipeline System in the 1970’s, initially was a consortium of BP, ARCO, ConocoPhilips, Exxon, Mobil, Unocal, and Koch Alaska Pipeline Company. – Intrapreneurs Executives, scientists, salaried employees engaged in commercial R&D activities –

27. Entrepreneurs doing their own thing Forming start-ups – Focus on creating and introducing a new product or employing a new production or distribution technique

28. Role of Entrepreneurs in the SG/NG Future Anticipate the future – Planning for a transition or – Focus on business as usual

29. A firm’s optimal amount of R&D Q. How does a firm decide on its optimal amount of R&D spending? A.Depends on its perception of MB and MC of R&D. Present sacrifice versus future expected gain Interest-Rate Cost-of-Funds – the MC – Several ways of obtaining funds for R&D. Bank Loans – cost of using the funds (interest rate) Bonds – MC of using the funds (interest rate) Retained Earnings – MC of using the funds (interest rate) Venture Capital – MC of venture capital – share of profits (interest rate) Personal Savings – MC is the foregone (interest rate) Marginal cost of getting the funds – interest rate Graph of the MC of each funding amount yields the interest-rate cost-of-funds curve. Expected Rate-of-Return – the MB – The firm’s MB from R&D – expected profit (or return) from the last (marginal) dollar spent on R&D. – Expected, not certain – Expected-Rate-of-Return-Curve

30. Interest-Rate Cost of Funds Rate Expected-Rate of Return Schedule R&D $10 20 30 40 50 60 70 80 Exp. Ret. % 18 16 14 12 10 8 6 4 20 16 12 8 4 020406080100 R&D Expenditures (millions of dollars) A FIRM’S OPTIMAL AMOUNT OF R&D Expected Rate of Return, - r, Interest Rate i r Expected-rate of return curve (MB curve)

31. Interest-Rate Cost of Funds Rate 8% Expected-Rate of Return Schedule R&D $10 20 30 40 50 60 70 80 Exp. Ret. % 18 16 14 12 10 8 6 4 20 16 12 8 4 020406080100 R&D Expenditures (millions of dollars) A FIRM’S OPTIMAL AMOUNT OF R&D Expected Rate of Return, - r, Interest Rate i r i Interest-rate cost of funds curve (MC curve)

32. Interest-Rate Cost of Funds Rate 8% Expected-Rate of Return Schedule R&D $10 20 30 40 50 60 70 80 Exp. Ret. % 18 16 14 12 10 8 6 4 20 16 12 8 4 020406080100 R&D Expenditures (millions of dollars) Expected Rate of Return, - r, Interest Rate i Optimal R&D Expenditure $60 Million r i r = i A FIRM’S OPTIMAL AMOUNT OF R&D

33. Expected Rate of Return, - r, Interest Rate i Interest-Rate Cost of Funds Rate 8% Expected-Rate of Return Schedule R&D $10 20 30 40 50 60 70 80 Exp. Ret. % 18 16 14 12 10 8 6 4 20 16 12 8 4 020406080100 R&D Expenditures (millions of dollars) Optimal R&D Expenditure $60 Million r i r = i Two Important Points: Optimal vs. Affordable R&D (MB vs. MC) Expected, not Guaranteed, Returns A FIRM’S OPTIMAL AMOUNT OF R&D

34. Increased profit via innovation Q.How does technological change increase a firm’s profit? A.By increasing revenue or reducing production costs. *

35. Increased Revenue via Product Innovation Thousands of new products introduced each year – All reflect technological advance in the form of product innovation.

36. Increased profit via innovation Q. How do such new products gain consumer acceptance? only if it increases the total utility they obtain from their limited incomes. A.Consumers will buy a new product only if it increases the total utility they obtain from their limited incomes. “ Dollar votes” represent new product demand that yields increased revenue. Total profit rises by the per-unit profit multiplied by the number of units sold. The rise in total profit is the return on that R&D expenditure – the basis of the expected rate of returns curve.

37. Related Points – Importance of Price Consumer acceptance of a new product depends on both its marginal utility and its price. To be successful, a new product must not only deliver utility to consumers but do so at an acceptable price. Consider marginal utility per dollar. – Unsuccessful New Products Millions of dollars of R&D and promotion expense resulted in loss. What are some examples? – The new coke – Ford Edsel – McDonald’s Arch Delux Increased profit via innovation

38. Related Points – Product Improvements Most product innovations consist of incremental improvements to existing products rather than radical inventions. Pringles Increased profit via innovation

39. The introduction of better methods of producing products (process innovation) (Cost Reduction) is also a path toward enhanced profit and a positive return on R&D expenditures. Introduction of a new and better process – The innovation yields an upward shift in the firm’s total product curve – A downward shift in the firm’s average-total-cost curve. – Enhances the firm’s profit. Reduced cost via process innovation

40. Increased Profit via Innovation TP 1 TP 2 ATC 2 ATC 1 $5 4 Total Product Average Total Cost Units of Labor Units of Output 0 0 2000 2500 Process innovation yields more output per unit of labor 100020002500 And lowers the cost per unit of labor and enables a greater output

41. The case of Wal-Mart – Wal-Mart computer based inventory control system – Just in time delivery of inventory – Transportation innovations – Distribution systems Reduced cost via process innovation

42. Imitation and R&D incentives Fast-Second Strategy The dominant firm counts on its own: product improvement abilities, marketing prowess, or economies of scale to prevail. – reverse engineering – let smaller firms incur the high costs of innovation, then move quickly to imitate. – Goal is to become the fast second *

43. Fast Second Strategy - Examples Then First – Royal Crown Cola

44. First Low Calorie Beer Then Fast Second Strategy - Examples

45. Imitation and R&D incentives Benefits of Being First Q.What incentive is there to be first given the ease of imitation? protections A.There are some protections for and potential advantages. Some inventions can be patented protection for 20 years Prescription drugs

46. Imitation and R&D incentives Benefits of being first Polaroid’s patent on the instant camera Patents Kodak “clone” Polaroid won

47. The Patented Pop Top Can The “Church Key” Imitation and R&D incentives Benefits of being first

48. Imitation and R&D incentives ProtectionsTrademarks give the original innovator of products the exclusive right to use a particular product name

49. Imitation and R&D incentives Protections:Copyrights protect publishers from having their works copied: books, computer software, movies, videos and musical compositions video games

50. Imitation and R&D incentives Protections: Patents Trademarks Copyrights By reducing the problem of direct copying, these legal protections increase the incentive for product innovation, for being first.

51. Imitation and R&D incentives Brand-Name Recognition Brand-Name Recognition may give the original innovator a major marketing advantage for years. – We often identify a product with the firm that first introduced it Levi’s blue jeans or Dockers Kleenex tissues Johnson and Johnson’s Band-Aids Kellogg's Corn Flakes Xerox copiers Disney Brand equity - measures the total value of the brand to the brand owner, and reflects the extent of brand franchise Brand promise - "Carl's Steak House -"Our food is the best, but the memories we help you create are even better” Brand personality – serious, playful, warmth

52. Imitation and R&D incentives Trade Secrets Coca-Cola’s secret formula Chemical industry Seeds Learning by doing The development of special production techniques known only to the innovator. Chemical industry Cosmetics The innovator’s lower cost may enable it to continue to profit even after imitators have entered the market.

53. Imitation and R&D incentives Time lags between innovation and diffusion often enable innovators to achieve substantial economic profit. Competitor must: – gain knowledge – design a substitute product – gear up a factory – conduct marketing campaigns – acquire customers

54. Imitation and R&D incentives Profitable Buyouts Significant advantage of being first Jibbitz – accessories for Crocs shoes, bought out by Crocs for $20 Million.

55. Role of market structure Is there a particular market structure or firm size that is best suited to technological advance? Pure Competition – Positive Strong competition provides strong incentive Many firms, no stone unturned – Negative Expected rate of return may be low or negative Advantage quickly lost to new entrants, other firms Normal profit in the long run

56. Role of market structure Is there a particular market structure or firm size that is best suited to technological advance? Monopolistic Competition – Positive Cannot afford to be complacent Strong profit incentive Start out as monopolist competitors locally and grow – McDonald's, Blockbuster Video, Krispy Crème Donuts – Negative Most remain small, limited resources to fund R&D Long run normal profit typically

57. Role of market structure Is there a particular market structure or firm size that is best suited to technological advance? Oligopoly – Positive Large size, financial resources Barriers to entry Large sales volume – Negative Often, low incentive to innovate Complacency can be a problem Avoid making current equipment obsolete Steel, cigarette, and aluminum industries only modest interest in R&D.

58. Role of market structure Is there a particular market structure or firm size that is best suited to technological advance? Pure Monopoly – Little incentive to innovate – Defensive action if threatened – Least conducive to innovation

59. Inverted -U theory of the relationship between market structure and technological advance MORE COMPETITION LESS COMPETITION R&D Expenditures as a Percent of Sales Concentration Ratio (Percent) 0 25 50 75 100 R&D expenditures as a % of sales rise With industry concentration until the Concentration ratio reaches about 50%. Pure competition Pure monopoly Loose oligopoly

60. Technological advance and efficiency Improves Productive Efficiency – By increasing the productivity of inputs – By reducing average total costs – Society can produce the same amount of a particular good or service while using fewer scarce resources, freeing up unused resources to produce other goods and services. – Leads to shifting an economy’s production possibilities curve rightward. Are there limits to increases in efficiency?

61. Technological advance and efficiency Improves Allocative Efficiency – Technological advance as embodied in product (or service) innovation enhances allocative efficiency by giving society a more preferred mix of goods and services. – Demand for new products goes up – Demand for old products goes down – Resources continue to shift until the price of the new product equals its MC.

62. Technological advance and efficiency Facilitates Creative Destruction – New products and new production methods simultaneously destroy monopoly market positions or firms committed to existing products or production techniques. – Examples 1800’s wagons, ships, and barges - the railroad Railroads – trucks and airplanes Snail mail - Email Sears and Kmart - Wal-Mart

63. technological advance very long run invention patent innovation product innovation process innovation diffusion start-ups venture capital interest-rate cost-of-funds curve expected-rate-of-return curve optimal amount of R&D imitation problem fast-second strategy inverted-U theory of R&D creative destruction