1. ECONOMICS of INNOVATION
The modern, knowledge-based economy characterized by: rapid innovation; a dramatic increase in the rate of production of information and decline in the cost of producing it; and pervasive network externalities or increasing returns to scale.
Emphasis is on the role of patents and alternative mechanisms for creating incentives for firms to innovate.
Topics include: why there may be too much innovative activity; how patent laws may slow rather than help innovation; and the interaction between public and private sector innovation

2. What is economics of innovation about?
Applying economic analysis to the understanding of the innovative process
Determinants
Consequences
Market failure (are optimal resources devoted to innovation)
Some key questions
What drives innovation?
How does intellectual property influence innovation?
Which market structures yield more or better innovations?
Why are some countries rich and some poor?
Is economic regulation good or bad for innovation?

3. What is the ‘economics of innovation’?
Microeconomics – understanding processes, including how incentives affect firms Macroeconomics – ‘innovation’ drives economic growth.. and economic growth drives living standards, environmental, political… Economic Policy – are there market failures in the innovation process and what, if anything, should the government do? Business Strategy – why and how business innovate? advising firms how to innovate

4. Definition of innovation
Basic definition
Introduction of new ideas that add ‘value’ to a firm’s activities
OECD The Oslo Manual (1997, p.28)
introduction of a new product or a qualitative change in an existing product
process innovation new to an industry
the opening of a new market
development of new sources of supply for raw materials or other inputs
changes in industrial organisation

5. Innovation and business
Some students may benefit from a brief comment on why innovation is so important to business
Some example of quotes
"Business has only two functions, innovation and marketing." Peter F Drucker
“Creativity is thinking up new things. Innovation is doing new things.” Theodore Levitt (management guru)
Innovation distinguishes between a leader and a follower.“ Steve Jobs

6. The innovation process
Figure 1.1 Greenhalgh and Rogers (2010)

7. Invention, Innovation, Diffusion (Schumpeterian trilogy)
Invention: creation of an idea to do or make something (profitability not yet verified)
Innovation: new product/ process commercially valuable i.e. successfully developed inventions.
Diffusion: the spread of a new invention/innovation throughout society or at least throughout the relevant part of society.
Without this cannot gain full benefits
Some of this represents ‘spillovers’ or ‘positive externalities’

8. Scientists, Knowledge and Technology
Discover knowledge by research
Disseminate knowledge (open science?)
Knowledge is public good(non-rival in use), hence created externalities
Universities, government labs, some large firms
It may represent the basis for technological advances
Technology
Application of knowledge to ‘production’
Firms driven by profit incentive
Private good: investment (R&D) projects, appropriate, use of intellectual property

9. Product and process innovations
Product innovations
product used by consumers
Microwaves, computers, mobile phones, etc
Products use by firms
Shipping containers, computers, robots, etc
Process innovations
Used by consumers
Fast food, air travel
Used by firms
Assembly lines, software

10. Defining an innovation
Can be defined as new to
Firm
Market (industry)
World
No universal agreement of which
Radical vs incremental
Radical (steam, internal combustion engine, computers, internet)
Incremental (constant improvements)
Both important in driving economic growth

11. Further ideas Can extend the introduction by considering
Further examples of specific innovations, including cases studies of famous innovations
Look at country / state / city comparisons of innovativeness
Can provide overview of productivity, economic growth, etc

12. Microeconomic effects of innovation
Figures 1.2 shows the effects of process innovation in a competitive market, which are an increase of the social welfare (consumer surplus plus producer surplus). Figure 1.3 shows how in the case of a monopolistic market the raise of social welfare is less than in a competitive market.

13. Figure 1.2 Process innovation in perfectly competitive market

14. The Effects of Product Innovation
The successful development of a new product results in a different configuration of changes in costs and rewards. In a perfectly competitive market, and in the absence of IPRs over the new product (i.e., we assume that any product innovation can be immediately copied), there is no gain to the innovator. This case of immediate imitation by all other firms in the market is very unlikely.
More realistically, the innovator uses some form of IPR or, failing this, relies on secrecy or first-mover advantages to delay imitation (the same would be true in the process innovation case discussed above). Given this, we can represent the introduction of the new product with a new demand curve.

15. Figure 1. 4 shows the demand curve for a new consumer good
Figure 1.4 shows the demand curve for a new consumer good. The position and elasticity of the demand curve depends on how much the new product is valued, which in turn depends on the availability of substitute products. If we assume that the firm has an IPR that prevents imitators, the firm acts like a monopolist and maximizes profits.
Hence, figure 1.4 is the same as figure 1.3 except that it represents a new product. Note that the new product creates “consumer surplus”: the triangular area above the price but below the demand curve. This is a measure of the surplus value to the consumers over and above the price they have to pay.
However, because price (P1) is greater than marginal cost (MC1), consumer surplus is not maximized, since this would occur at Q∗.

16. It is clear that rewarding innovations with profits (i. e
It is clear that rewarding innovations with profits (i.e., allowing P to be greater than MC) creates a further problem. Looking at figure 1.4, we can see that some of the lost consumer surplus is, in fact, profits to the innovator (i.e., area ABCD), but some of the lost consumer surplus is wasted (i.e., area BDE). For this reason, area BDE is called the “deadweight loss” associated with monopoly pricing. Consider as an example the situation where an important new drug, that can treat a serious disease, is developed.
During the period of protection by a patent, it is sold at a higher price than its marginal cost of production. Some sufferers who could afford the drug if priced at marginal cost are not able to obtain it at this higher price; the number of people affected is proportional to the distance Q∗−Q1.

17. Figure 1.3 Process innovation for a monopoly

18. Figure 1.4 New product demand curve: Product innovation for a monopoly

19. If the product innovation creates a new variety or improves the quality of an existing product, then drawing a new demand curve is not the best way to conceptualize the change.
Suppose the market is imperfectly competitive before this product innovation, hence the firm already faces a downward-sloping demand curve. By introducing a new product the firm aims to achieve an outward shift and steeper slope to the demand for its product (analogous to the effect of advertising, increasing product loyalty to the firm). Figure 1.5 shows such a demand shift. Note that even though consumers are charged a higher price, they buy more and have more consumer surplus. Of course, over time the market may become more competitive as more product innovation occurs and this may reduce prices.

20. Figure 1.5 A product innovation represented by a shift in existing demand curve

21. A general way of describing this situation is to say that consumers benefit from the increase in product variety and/or the rise in the quality of the products on offer. Even if a new product is more expensive than existing ones, if it has exactly the right set of characteristics to match the customers’ tastes, they may be happier to buy this item. If the product has a broader and more favorable set of characteristics than an earlier variety, then, even with a higher price, it can still be seen as good value for money.

22. Effects of innovation:
Cost cut (Higher productivity)
Demand increase
New market
Welfare effects
GNP increase (economic development) +
Market displacements (redistributive effects) – +
Structural and competitive changes (firms and national economies) - +
Higher product variety (consumer choice)+

23. Innovation and business strategies

24. ENTREPRENEURSHIP AND ENTREPRENEURIAL OPPORTUNITIES
Are opportunities others do not see or for which they do not recognize the commercial potential
Are conditions in which new products or services can satisfy a need in the market
Exist due to competitive market imperfections and unevenly distributed information
Are studied at the level of the individual firm
May be the economic engine driving many nations’ economies in the global competitive landscape

25. ENTREPRENEURSHIP AND ENTREPRENEURIAL OPPORTUNITIES
Creative Destruction
(Schumpeter)
Entrepreneurship, as a process, results in the ‘creative destruction’ of existing products (good or services) or methods of producing them, and replaces them with new products/production methods
Entrepreneurial firms value individual innovations and the ability to continuously innovate across time

26. KEY CHAPTER POINTS THREE ‘I’s ● Invention THREE WAYS TO INNOVATE
Three types of innovation activities according to Schumpeter
● Invention
● Innovation
● Imitation
THREE WAYS TO INNOVATE
● Internal - autonomous vs. induced
● Cooperative strategies (e.g., strategic alliances)
● Acquisitions

27. INNOVATION
Innovation is the “specific function of entrepreneurship” (Drucker)
It is “the means by which the entrepreneur either creates new wealth-producing resources or endows existing resources with enhanced potential for creating wealth” (Drucker)
It is a source of competitive success, especially in turbulent and highly competitive environments
For global markets, innovation is key for competitive parity at a minimum, much less for competitive advantage

28. INNOVATION
Invention
The act of creating or developing a new product or process
Brings something new into being
Technical criteria determine the success of an invention

29. INNOVATION Invention Innovation
Process of creating a commercial product from an invention
Brings something new into use
Commercial criteria determine the success of an innovation
Innovation

30. INNOVATION Invention Innovation Imitation
Adoption of an innovation by similar firms
Usually leads to product or process standardization
Products based on imitation often are offered at lower prices and without as many features
Results of imitation
Product or process standardization
Products made with fewer features
Products offered at lower prices
Innovation
Imitation

31. THE IMPORTANCE OF INNOVATION
Entrepreneurship is the linchpin between invention and innovation
Inventions are easier than commercializing those inventions: roughly 80% of R&D occurs in large firms, but these same firms produce fewer than 50% of the patents
Note: Google Labs was created to facilitate the transition from invention to innovation
Especially in the U.S., innovation is the most critical of the three types of innovative activities

32. Porter’s legacy The five forces: Relations with suppliers
Relations with buyers
New entrants
Substitutes
Rivalry among established firms
”the goal of competative strategy is to find a position where a company can best defend itself against these forces or influence them to its benefit”

33. Porter’s legacy Generic technology strategies:
Cost leadership (e.g. Lower/cheaper material input, logisitics)
Differentiation (e.g. Enhance features, deliverability)
Cost focus (minimum features)
Differentiation (niche markets)
Don’t get stuck in the middle!

34. Innovation and market failures (Incentives for inventions are needed)
Because of the positive externalities associated with the dissemination of information (which is a public good) on new discoveries.
To cerate new products firms invest large amount of money in Research and Development (R&D) activities.
Since innovators cannot seize all the gains stemming from innovation, they make R&D investments lower than those required to achieve the social optimum.

35. Restoring incentives to invent and innovate
Governments can correct this form of market failure through different forms of interventions:
Public provision of a public good (public research)
Subsidizing firms’ research costs (research contracts, fiscal incentives)
Joint public-private R&D
Prizes
Intellectual Property Rights (IPR) laws: Patent, Copyrights, Trademarks

36. Subsidies for R&D (Pigovian subsidies)

37. Defining Intellectual Property Rights
Intellectual property rights are intangible rights. Unlike other personal property rights, they cannot be touched, or seen. For example, a copy of a book is a personal asset that is easily viewed and identified. Copyright does not prevent you from reading the book, or giving your copy of the book to another person. But the copyright does protect the expression of the words and ideas in the book, and it is that expression that is protected, not the physical copy of the book itself.

38. Patents
A patent gives the owner the exclusive right to manufacture, use and sell the invention claimed in the patent, and the ability to prevent others from doing the same.
Of all of the intellectual property rights, patents grant the most exclusivity and the greatest amount of protection in respect of the patented invention.
A patent will protect the ideas embodied in the claimed invention, and not just the expression of it.
Even if you independently develop the same invention on your own, without any knowledge of the patent, you can still be barred from making, using or selling your invention until the patent that claims it has expired.

39. Trade-marks
Trade-marks rights, if registered, give the owner the exclusive right to the use of the trade-mark (in a particular country) in respect of the wares and services associated with it, and the right to prevent others from using the same or confusingly similar marks.
A trade-mark may be a word or combination of words, designs, symbols, colours, fragrances or the “get-up” of a package or product.
Trade-mark rights do not necessarily have to be registered, as the right itself is acquired through use of the trade-mark that designates the source of origin of goods and/or services with which the trade-mark is associated.
Owners of unregistered trade-mark rights can prevent a third party from using their trade-marks, but only if they can establish that the third party is attempting to deceive the public by “passing-off” its goods and/or services as those of the trade-mark owner.

40. Copyright
Copyright gives its owner the sole right to produce or reproduce the protected work. Copyright can subsist in any original literary, artistic, musical or dramatic work, or any substantial part thereof, in any material form whatever.
The copyright arises automatically upon creation of the work – no registration is required, although registration does offer some limited presumptions of validity in the event of litigation.
Copyright offers a far more limited scope of protection than a patent, because it protects the expression of the original work, but not the underlying ideas. As long as there is no actual copying involved, anyone can produce a similar work even if they are using the same underlying ideas.

41. The economics of patents

42. Because of the breadth of exclusivity afforded to patent holders, patents are more difficult to obtain than other forms of intellectual property rights.
A patent must be issued by the Intellectual Property Office according to a Country’s legislation.
Generally, in order to be issued a patent, the invention must meet all four of the following requirements:

43. Patentable Subject Matter
Any new and useful art, process, machine, manufacture or composition of matter, orimprovement, can be the subject of a patent. Scientific principles, mathematical equations and other like “inventions” are not patentable subject matter.
Novelty:
The invention must not have been disclosed in a manner such that that it had become available to the public prior to the filing date of the application (if the disclosure was by a third party), or prior to one year before the filing date of the application (if the disclosure was by the inventor).
Non-Obviousness:
The invention must reflect some amount of inventive ingenuity; in other words, it must not be obvious to a skilled professional in the art, having regard to all of the other information and prior art available to him or her.
Utility:
The invention must serve some functional purpose and it must deliver the results promised in the patent, if any.

44. The trade off between innovation benefits and monopoly power
Patents, which grant exclusive right to successful inventors, induce research. Unlike prizes or government research contracts, however, patents lead to distortions due to monopoly pricing.
The definition of patent length is crucial for optimizing social welfare.
By having patents last shorter periods of time, the government can reduce the incentive for excessive research. Having rights for only t years reduces the present value of the flow of monopoly profits; thus the expected private benefit to each firm is lower , so fewer firms engage in research.
The government is faced with a trade-off: the longer the patent, the grater the inducement for research but the larger the cost due to more research projects and the monopoly loss. Given that government uses patents, then, it should chose the length t to maximize expected social benefits, taking into account monopoly pricing.