1. ECON 330 Lecture 25
Tuesday, December 25

2. Study questions (with answers) part 1 is posted on webpage
A smaller part 2 will be added later
A review session will be scheduled before the final exam
Thursday: “Review/tips for final” lecture

3. Research and Development
and market structure

4. The central question
What is the relation between market structure and R&D?
Last week Tuesday’s lecture:
How does market structure affect the level and direction of R&D?
Today:
How does R&D influence the evolution of market structure?

5. What market structure is best for innovation (R&D)?
We compared a monopolist’s incentives to innovate to a competitive firm’s incentives to innovate. We considered a firm’s incentive to do R&D to reduce its cost.

6. The (theoretical) result (Kenneth Arrow): The competitive firm has stronger incentives to innovate than a monopoly firm.
Intuition: For the monopolist the new process takes away the profits generated by the old process and replaces them with new profits.
For the monopolist, this represents a loss of “old profits”.
The competitive firm earns zero profit before innovation (i.e., with the old process), hence there is nothing to “replace”.

7. Replacement effect: The monopoly firm’s disincentive (for innovation) created by the pre-innovation monopoly profits.

8. Today’s lecture: What is the effect of R&D on market structure?
Does R&D contribute to a process of increasing dominance?
Market leaders increase their lead and monopolists persist as such; or
New firms constantly replace incumbents. (Schumpeter’s “creative destruction”, also known as “leapfrogging”)

9. Persistence of leadership/dominance or ‘leapfrogging’?
A monopoly (or dominant firm) using older technologies has less incentive to innovate than potential rivals. This means that it will lose the technological leadership role when innovations are adopted by new firms. With their new technology the newcomers (entrants) leapfrog ahead of the former leading firm.

10. Now a very simple model

11. The dynamics of R&D competition
Assume there is one incumbent and one potential entrant. Add a third player: The R&D lab. The lab has discovered and patented an innovation. It will sell the patent rights to the highest bidder. Question: Which firm will bid more? We are modeling the R&D race for innovation as a bidding process on the patent rights.

12. A short digression: Patents, definition, etc.
A patent provides an inventor with exclusive rights to a new and useful product, process, substance or design(including improvements on existing products, processes and substances).
A patent provides the right to exclude others from making, using, selling, offering for sale, or importing the patented invention.
In exchange for these exclusionary rights, the patent holder must disclose the invention as part of a publicly available patent document.

13. Patents need to meet three legal requirements
1. Novelty
the technology must not be "anticipated" or identical to an invention disclosed in a single piece of prior art.
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.

14. Black patent leather shoes
Patented leather is black leather finished to a hard glossy surface and used especially for shoes and clothing accessories.
So called because it is made by a once-patented process.

15. From George Symeonidis, lecture notes for EC261: MANAGEMENT OF NEW TECHNOLOGYSE

16. 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

17. Back to the model
Assume there is one incumbent and one potential entrant.
Add a third player: The R&D lab.
The lab has discovered and patented an innovation. It will sell the patent rights to the highest bidder.
Key assumption: The entrant enters only if he or she gets access to the new technology.
The monopolist acquires the patent: continue as monopoly, earn πM. The entrant earns 0.
The entrant acquires the patent, enters the market. The market becomes a duopoly, each firm earns πD.

18. Who has a stronger incentive to innovate?
The monopolist is willing to pay at most πM – πD The entrant is willing to pay at most πD The monopoly will pay more for the innovation if πM – πD > πD. This can be written as πM > 2πD.

19. The condition πM > 2πD
Result: The incumbent’s incentive to innovate is greater than that of the entrant. Intuition: because innovation and entry leads to greater competition the incumbent has more to lose (efficiency effect). “Sleeping patents” (Gilbert and Newbery, 1982).

20. Variations on the model: With probability ρ the rival will not bid.
If no firm bids, the patent will remain unused.
The monopoly
bids and acquires the patent: profit = πM
doesn’t bid: profit = ρπM + (1–ρ)πD.
The monopoly will bid up to
πM – [ρπM + (1–ρ)πD]
= (1–ρ)(πM – πD)
The rival will bid up to πD

21. Who wins?
The entrant wins the R&D race if πD > (1–ρ)(πM – πD). If there is sufficient uncertainty about the presence of a rival, the monopolist will pay less for the innovation that the rival.

22. Another variation: Gradual vs. drastic innovation
Drastic innovation: If the entrant acquires the patent and enters the market the incumbent’s profit will be 0, the entrant will earn monopoly profit.

23. Who wins the race for the drastic innovation?
The monopoly
bids and acquires the patent: profit = πM
doesn’t bid: profit = ρπM + (1–ρ)0.
The monopoly will bid up to
πM – [ρπM + (1–ρ)0]
= (1–ρ)πM
The rival will bid up to πM

24. Who wins? The entrant wins if πM > (1–ρ)πM.
The monopolist is willing to pay less for a drastic innovation than the rival.

25. Summary
Incumbent firms have a greater incentive than the entrants to perform R&D toward a gradual innovation.
If there is uncertainty about the threat of entry or if the innovation is sufficiently drastic, then the outsiders may have a greater incentive to perform R&D than the incumbents.

26. Now a slightly different storyline

27. A model with multiple (sequential) innovations
There are three (constant marginal) cost levels: cH At the pre-innovation stage both firms have MC = cH. cH > co cH > co > cL

28. There are two rounds of innovation: In round 1 each firm bids for the exclusive rights to a technology that lowers the cost to co. The winner of round 1 will have MC = co, while the other firm will have MC = cH. In round 2 each firm bids for the exclusive rights to a technology that lowers the cost to cL. The round 2 winner will have cost cL.

29. How much will a firm bid? A firm will bid up to the difference in its profit between getting and not getting the technology in a given round.

30. Round 1 is easy
The high-cost firm cannot price below cH. The low-cost firm will price at slightly below cH and serve the entire market demand, selling Q units and obtaining a profit of cH co

31. Both firms have an equal chance of winning the R&D race in round 1
Pre-innovation profit is 0 for both firms. Post-innovation profit for the winner: (cH–co)Q Both firms can win. Say firm A wins in round 1.

32. What happens in round 2?
The winner of round 2 has MC = cL. The winner will price at slightly lower than the loser’s cost. The round 1 winner has a greater incentive to win in round 2 as well. This leads to “persistence”. cH co cL

33. Now it is your turn

34. Cournot competition: Leapfrogging or Persistence?
Example Inverse demand: p = 20 – Q cH = 3, co = 2, cL = 1. Profits in the Nash equilibrium (Cournot competition) Firm A has MC = cA, Firm B has MC = cB πA = (20–2cA+cB)2/9 πB = (20–2cB+cA)2/9

35. cA 3 2 1 cB
profit A 32 40 49
profit B 28 25 44
Suppose A wins the R&D race in round 1. Which firm will win the R&D race in round 2? Do we have persistence of leapfrogging in this industry? Please explain.

36. End of lecture

37. Course evaluations 019837 019838 Murat Usman ECON 330 Lec1 Fall 2012
MGEC 330 Lec1
Fall 2012
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