1. ECON 330 Lecture 24
Tuesday, December 18

2. THIS THURSDAY, DECEMBER 20th: COURSE EVALUATIONS

3. Today’s lecture Entry deterrence and predation
Research and development

4. Last lecture: We talked about “entry deterrence”.
Strategies that incumbent firms use to try to stop new firms entering their profitable markets.
Output/capacity expansion
Product/location proliferation

5. Now a slightly different story
Predation: Forcing the rivals to exit

6. Predation
An incumbent can gain monopoly power by inducing the exit of its rivals.
To achieve this goal the incumbent usually charges a very low price.
This is called predatory pricing. This kind of behavior is called predation.
Predation is illegal.

7. Predation (Cont’d)
If the incumbent is charging a price below marginal cost, then it is clear that it is engaged in predation.
But the firm’s marginal cost is difficult to measure, especially for the court.
In reality, it is very difficult to distinguish competitive behavior (a very low price-cost margin) from anti-competitive behavior (pricing below cost to induce the exit of rivals).

8. The Chicago school’s view on predation
A rational firm should never exit when preyed upon.
Consequently, rational firms should never engage in predation.

9. What does that mean? Consider a simple two-period model.
In the first period, both the incumbent (I) and the entrant (E) are in the market.
In the second period, the entrant may exit.

10. A simple model of predation
If I chooses predation (sets low prices), both I and E make a loss of –L in that period.
If I does not choose predation, both I and E get a duopoly profit: πD.
If E exits, then I gets the monopoly profit πM in the second period.

11. Lets start with the second period.
Suppose E stayed.
What is I’s optimal action? Predation or no predation?
I’s optimal action is no predation.
I’s profit in second period: –L if predation, πD if no predation

12. So, no predation is expected in period 2.
Then E will not exit no matter what I does in the first period.
Anticipating that E will stay in the second period, I has no incentive to do predation in the first period.
I’s threat of predation in the second period is not credible. (convincing, believable)

13. Long-purse theory
What if E doesn’t have enough cash to sustain the loss L?
Perhaps it can borrow money from a bank?
Possible if πD > L.
The assumptions underlying the Chicago school argument.
Firms and banks are rational.
Information is perfect.

14. Long-purse theory (Cont’d)
Suppose E does not have enough cash to sustain losses in the first period, and has to borrow money from banks to survive in the first period.
Due to asymmetric information, banks maybe not willing to lend money.
Suppose that banks will refuse a loan with probability x.

15. Remember x is the probability that E will exit after suffering losses in period 1
After predatory pricing by I in the first period, E will stay in the second period only with probability 1 ‒ x. I’s expected payoff to predation is: ‒L + (1‒x)πD + xπM. I’s expected profit to no predation is: 2πD. Predation is optimal if ‒L + (1‒x)πD + xπM > 2πD. Rewrite this condition as xπM > (1+x)πD + L.

16. Long-purse theory (Cont’d)
The key difference is that one firm (Entrant) is financially constrained while the other (Incumbent) is not.
It is also called deep-pocket theory.

17. Research and Development

18. R&D is the “engine of technological change”
Economic growth is caused primarily by technological progress.
Firms become industry leaders by conducting R&D that leads to innovations in products and processes.
Firms may lose their markets if new products and processes are developed by entrants.
(This is Schumpeter’s process of “creative destruction”)

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

21. What is the relation between market structure and R&D?
The central question
What is the relation between market structure and R&D?
First question: How does market structure affect the level and direction of R&D?
Second question: How does R&D influence the evolution of market structure?

22. Question #1
What market structure is most conducive to innovation: monopoly or perfect competition?
Two views:
Joseph Schumpeter: Firms with market power (monopolies) innovate more.
Kenneth Arrow: Competitive pressure makes firms do more R&D.

23. Kenneth Arrow won the Nobel Prize in Economics (with Sir John Hicks) in To date, he is the youngest person to have received this award, at 51.

24. Research findings
There is an extensive literature on how market structure affects R&D.
The effect of industry concentration on innovation activity seems to be relatively weak.
There is evidence for
some association between firm size and innovation
a U-shaped relation between competition and innovation

25. The famous graph

26. R&D activity and firm size link
Likelihood of undertaking R&D greater the larger a firm
R&D increases monotonically and typically proportionately with firm size among R&D performers within industries
Number of innovations tends to increase less than proportionately with the firm size
R&D productivity declines with firm size

27. Question #2 How do the dynamics of R&D effect the market structure?
Does R&D contribute to a process of increasing dominance?
Possibility 1: Market leaders increase their lead and monopolists persist as such
Possibility 2: (What Schumpeter called the process of creative destruction) New firms constantly replace incumbents.

28. There is an interesting parallel between this question and the macroeconomics literature on growth and convergence.
Do rich countries tend to become even richer or do poor countries tend to catch up?

29. From a normative point of view, there are two important questions
Issue #1: The antitrust treatment of R&D agreements between firms.
Public policy has normally been distrustful of agreements between firms (like price fixing, etc.)
But, there are reasons to make R&D an exception to this general stance: cooperation in R&D is not illegal.

30. Issue #2: The protection of intellectual property (IP)
Issue #2: The protection of intellectual property (IP). Patents, copyrights, etc.
The basic trade-off: maximizing allocative efficiency versus providing the right incentives for investment in R&D.
In other words, the trade-off is between static and dynamic efficiency.

31. The fundamental question: What should the copyright law state?
The development of the internet has created many new Intellectual Property issues, both related to patent law and to copyright law.
Should Amazon.com be given a patent for "one-click shopping"?
Did Napster.com violate copyright law?
The fundamental question: What should the copyright law state?

32. Now: How does market structure influence the R&D activity?
Kenneth Arrow versus Joseph Schumpeter

33. Market Structure and Incentives for R&D
Consider a process innovation that lowers the MC from cH to cL. (cH > cL) Process innovation?

34. Some definitions
Process innovation: a better (lower cost) method for producing existing products.
Product innovation: new product.
Drastic innovation: big reduction in cost so that the innovator becomes a monopolist.
Non-drastic or gradual innovation: improves firm’s competitive position, but there still is competition.

35. Market Structure and Incentives for R&D
Consider a process innovation that lowers the MC from cH to cL. (cH > cL) What is the value of this innovation to the monopolist?

36. cH cL

37. Market Structure and Incentives for R&D
For a monopolist, the value of a process innovation that lowers the MC from cH to cL is (cH – cL)qM. Area A in the graph.

38. Suppose the market is competitive with many firms with constant MC = AC = cH. One of those firms innovates and reduce its cost to cL. What is the value to the innovating firm?

39. cH cL

40. If one of the competitive firms innovates and reduce its cost to cL, it will set price (slightly) below cH. Value to innovating firm is (cH–cL)qC. Area A + B in the graph.

41. The competitive firm has a greater incentive (A+B) to innovate than a monopoly firm (A).
This is Arrow’s argument: Competitive markets give stronger incentives to firms to innovate.

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

43. Schumpeter’s view
The atomistic firm in a competitive market is the suitable vehicle for static resource allocation, but the large firm operating in a concentrated market is the most powerful engine of progress and […] long run expansion of output […]. Perfect competition […] has no title to being set up as a model of ideal efficiency. Schumpeter (1942)

44. Research shows: Innovation activity seems to increase with firm size
R&D projects are risky and require large fixed costs
Large firms
have better access to finance or can finance R&D with own profits
are in better position to exploit unforeseen innovations.
can spread risk involved in R&D by undertaking many projects at the same time
can more easily appropriate the returns from innovation and therefore have better incentives to innovate

45. Incentives vs. capacity for innovation (R&D)
Way can’t small firms borrow to finance their R&D projects?
Capital markets are not perfect (especially for R&D financing)
Consider a venture capitalist (VC) negotiating with a small firm that has an R&D project.
To convince the VC the firm must disclose the idea.
Once the idea is disclosed, the VC can use it itself.

46. Incentives vs. capacity for innovation
The incentives for R&D are stronger in competitive industries (Arrow’s theory)
but
Large firms have the capacity to do R&D (financial, organizational, legal, etc.) (Schumpeter’s theory)

47. Back to the “The inverted-U theory” of innovation and market structure
Firms spend a relatively small percentage of their sales revenue on R&D in very low concentration industries and very high concentration industries.
The best market structure for R&D seems to be an industry in which there is a mix of large oligopolistic firms (a 40 to 60 percent concentration ratio) with several highly innovative smaller firms.

49. Now… The second question:
What is the effect of R&D on market structure?
Does R&D contribute to a process of increasing dominance?
Possibility 1: Market leaders increase their lead and monopolists persist as such
Possibility 2: (Schumpeter’s “creative destruction”.) New firms constantly replace incumbents.

50. 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.

51. 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.

52. 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.

53. 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).

54. Variation on the previous model: With probability ρ the rival will not bid.
We assume that if no firm bids for the patent it will remain unused Monopoly bids and acquires the patent: πM If it doesn’t bid: 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 Who wins? The entrant can win if πD > (1–ρ)(πM – πD).

55. 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.

56. 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.

57. Who wins the race for the drastic innovation?
The monopoly bids and acquires the patent: πM If it doesn’t bid: 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 Who wins? The entrant wins if πM > (1–ρ)πM. The monopolist is willing to pay less for a drastic innovation than the rival.

58. 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.

59. End of lecture