Innovation and Technology

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R&D and market structure

• Technological development contributes decisively to economic growth.

• Modern economic growth relies heavily on the production and application of scientific and technological knowledge.

• R&D increases productivity (a key determinant of economic growth), variety, and reduces costs.

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R&D and market structure

• Relative importance of R&D expenditures varies considerably across firms and across industries. Why?

• Firms in competitive industries have higher incentives to invest in R&D than monopolist firms (K. Arrow), but less capability (J. Schumpeter).

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R&D and market structure

• Monopolist firms must avoid cannibalization.

• Large firms benefit more from scale and scope economies in R&D, and spread the associated risks more easily.

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R&D and market structure

• Large innovation: the cost reduction is so large that the monopoly price falls below the perfect competition equilibrium price (with no innovation).

• Small innovation: the monopoly price is still higher than the perfect competition equilibrium price (with no innovation).

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R&D and market structure

• Does R&D lead to increasing dominance or, on the contrary, to smaller firms catching up the larger?

• Two types of innovation races:– Memoryless: probability of discovery is

independent of experience, depends only on current R&D expenditure

– Cumulating experience: probability of discovery increases with cumulative R&D expenditure

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R&D and market structure

• Gradual innovation: does not displace the existing product.

• Drastic innovation: renders the existing product obsolete.

• Uncertainty about the entry of rival.

• Gradual innovations by incumbents, drastic innovations by entrants.

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R&D and market structure• Low-risk strategy: make an innovation

which yields a low value with high probability.

• High-risk strategy: make an innovation which yields a high value with low probability.

• Low-risk strategies by market leaders (small innovations to their current products), high-risk strategies by outsiders (creating new products).

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R&D and market structure

• Learning economies are a source of persistent or even increasing dominance.

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R&D and market structure

• Product innovation: create new goods and services.

• Process innovation: reduce the cost of producing existing products.

• Uncertainty is intrinsic: will R&D generate new technology? Which is the impact on costs and demand? What will the reaction of rivals be?

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R&D spillovers

• There is not full apropriability of R&D results.

• Choosing between being a leader (faces uncertainty and development costs, but is able to patent the innovation) or being a later adopter or a “fast-second”.

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R&D spillovers

• Diffusion may not be instantaneous. Meanwhile the innovating firm is a monopolist.

• Knowledge diffusion increases productivity and fosters economic growth. Reduces inequalities.

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R&D spillovers

• R&D as a self-perpetuating process due to spillovers: innovation facilitates further innovation. Cumulative.

• The more a firm invests in R&D, the more able it is to capture spillovers from others’ innovation and benefit from the available “pool of knowledge”.

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Public policies towards R&D

• R&D spillovers: no market transaction, not paid.

• R&D as a public good? Yes, if spillovers are very high.

• The free-riding problem (replicating is cheaper than inventing).

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Public policies towards R&D

• Patents: apply to products, processes, designs.

• Copyrights: apply to works of authorship (books, software, art).

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Public policies towards R&D

• The trade-off in patent protection: higher incentives to innovate, but market power. Patents restrict diffusion of technology. The optimal patent life is finite (otherwise firms may have reduced incentives to continue innovating).

• Decide on length and strength (keep monopoly or sell some licences in order to allow some competition?) of patent protection.

• R&D level increases with the duration of the patent.

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Public policies towards R&D

• Subsidization of R&D may be a good substitute for a failing patent system.

• Award system: granting a sum of money to the first firm completing a specified project. Thereafter the innovation falls into the public domain. Unlike the patent system, does not produce a monopoly, but is more difficult to implement (requires knowledge about feasibility of inventions and about the existing demand for them). Duplication of research costs.

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Public policies towards R&D

• Stimulate the creation of markets for innovation and markets for technology (avoid that markets for these intangible assets be missing). Allows diffusion and adoption of new technologies (important when there are network externalities), and stimulates investments in new knowledge (further innovation).

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Public policies towards R&D

• Diffusion paths are usually S-shaped: few firms adopt early, then adoption accelerates as more firms learn about the invention, and then deccelerates when most firms have already adopted.

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Markets for innovation

• Markets for innovation: transactions for the creation of technology. (R&D agreements, contracts...)

• R&D agreements: internalize part of the spillovers, so increase incentives to invest by participants. But: may induce competitors to reduce their R&D levels (strategic substitutes).

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Markets for innovation

• R&D joint ventures: firms share the expenditures and the benefits associated with a given research project. Allow exploiting complementarities of members and prevent duplication of effort (costs).

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Markets for technology

• Markets for technology: transactions for the use and diffusion of technology (sell, license).

• Important in technology based industries such as chemicals, software, electronics, ...

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Markets for technology

• When selling is not an option (for example, small firms lack the downstream manufacturing and marketing capabilities), licensing may be the best way to appropriate the rents from innovation.

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Markets for technology

• Large firms license because:- they may not be efficient at exploiting the invention

(the technology has application in markets where the innovator does not typically operate)

- they want to establish their technology as a standard (recall importance of early adopters when there are network externalities – supply of complementary inputs) and deter rivals’ entry. Reduce the incentive of a potential entrant for developing its own (maybe superior) technology. Reduce the incentives of rivals to invent “around” the current innovation.

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Markets for technology• There are two opposite sign effects from

licensing:– the revenue effect (rents earned from licensing

payments)– the rent dissipation effect (from less to more

competition – eventually from monopoly to competition).

• For large and well-established firms the rent dissipation effect is more important, so these will tend to license less.

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Markets for technology

• Competition in the product market creates a strategic incentive to licence: the higher the degree of product differentiation, the more important is the rent dissipation effect, so the lower the profitability of licencing. Hence, licensing will be more widespread the lower the degree of product differentiation (which are more competitive industries).

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Markets for technology

• Markets for technology promote the diffusion and efficient use of existing technology.

• Reasons for not commercializing: fear of new competitors, fear of cannibalizing existing markets, belief that returns from licencing are small and licencing contracts inneficient.

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Markets for technology

• Markets for technology lower entry barriers and reduce concentration in the industry. They promote competition, so induce firms to lower costs.

• Firms must find other sources of differentiation, for this is unlikely to persist for a long time. Innovation accelerates.