14, 15. Innovation and technological change: Introduction Flashcards
Competitive markets are the ultimate goal
Perfect competition equilibrium:
p = MC = AC min
The maximum quantity of the good produced at the lowest possible cost= Max Productive efficiency (goods and services are produced using the least costly combination of resources and technology)
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The maximum quantity of the good sold at the lowest price= Max Allocative efficiency (resources are dedicated to the combination of goods and services that best satisfy consumer needs)
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But things are more complicated. These two types of efficiency are based on a static dimension. They do not consider that economy
is evolving over time
Dynamic efficiency —> Improvement and generation over time of new products and production techniques.
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extra:
We will be able to achieve these things tomorrow if we are able to make some investments today, in particular R&D investments. An economic system is efficient as long as it allows a good rate of new product generation and new production techniques over time.
Economic background (milestones); Solow
The first economist recognizing the importance of dynamic efficiency was Schumpeter in two books “The theory of economic development” and
“Capitalism socialism and democracy”. These two books put innovation as the main engine of economic growth. It is a real breakthrough with respect to the neoclassical tradition, whose main idea was more labor and capital mean more output.
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The first contribution showing innovation-related differences was Solow. He did not use sophisticated tools and econometrics. He decomposed economic growth recognizing that 87% economic growth in US was caused by technical change and innovation. It was the milestone putting innovation at the center of the stage in the economic analysis.
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Y = A(t)F(K,L)=A(t)K^θL^(1-θ)
Y (output) =
A (technology)
K (Capital) , L (Labor)
A(t)K^θL^(1-θ) = Cobb-Douglas with constant return to scale
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ΔY/Y (Rate of economic growth) = θ(ΔL/L)+ΔA/A (Technical change)
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Innovation has become the industrial religion. Business sees innovation as the key to increase profits and market share. All the firms think that innovation is an important driver for success in markets. Therefore, the new purpose is to foster innovation with all means at disposal.
For instance, research and innovation are placed at the center of the Europe 2020 strategy. This includes the headline objective of increasing spending on R&D to 3% of GDP by 2020. In 2000, the European goal was to create the most dynamic and competitive knowledge based economy.
For 2020, the purpose in to create a smart, sustainable and inclusive growth based on innovation. European Union wants to increase the R&D spending; it is an input to reach innovation as output. Now, Europe is very far from this objective.
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Griliches (1990, JEL) and the “CDM” Model (Crepon, Duguet & Mairesse, 1998, EINT)
R&D -> Innovation -> Productivity growth rates
Schumpeter was the first one separating three processes of innovation. It is called the trilogy of Schumpeter: invention, innovation and diffusion.
Schumpeter was the first one separating three processes of innovation. It is called the trilogy of Schumpeter: invention, innovation and diffusion.
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INVENTION (telephone):
(technological) materialization of an intuition which can be engendered by scientific knowledge. Might be exogenous and largely random in nature and can not be influenced by market signals. Can be a process of inspiration, perspiration, both of them, and also a result of “stumbling” over.
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INNOVATION (telecommunication service):
transformation of an invention into a new product/service/process.
It addresses new needs (often latent needs) on the part of consumers or firms; influenced by economic signals (like pursuit of profit).
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Diffusion (telecom penetration)
spread process of an innovation into the economy
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EXTRA:
Economic of innovation is important stream embracing all studies concerning innovation: it studies the nature, the characteristics, the determinants and the consequences of innovation and its diffusion at a level of firm, sector and economic system.
Schumpeter was the first one separating three processes of innovation. It is called the trilogy of Schumpeter: invention, innovation and diffusion.
- Invention is the materialization of an intuition. It may be scientific or not, driven by economic signals or not (exogenous in nature). Often it is a process of stumbling over and largely random in nature: someone wants to invent something and finds something completely different.
- Innovation is the transformation of an invention in a new service/product. It is influenced by market signals, such as the pursuit of profit. It addresses new, often latent, needs on the part of consumers or firms.
- Diffusion is the spread process of invention/innovation into the economy. Schumpeter stressed that diffusion is slow: innovators may find difficulties to penetrate the market with their innovations.
Ex-ante it could be difficult to understand the best purpose of the technology invented in order to transform it in an innovation.
REFERENCES
Cabral, Introduction to Industrial Organization (2000), I edition, chapter 16 and/or Introduction to Industrial Organization (2018), II edition, chapter 15
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Further reading:
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- Joseph, A. Schumpeter (1912-1934) . The Theory of Economic Development. An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle.
- Joseph, A. Schumpeter (1942) . Capitalism, Socialism and Democracy.
- Comino, Manenti, Industrial Organization of High-technology markets, chapter 6.
- Pepall, Richards, Norman, Industrial Organization: contemporary theory and empirical applications, chapter 18.
Schumpeter was the first providing a taxonomy of innovation:
PRODUCT VS PROCESS INNOVATIONS:
- Product Innovations refer to the creation of new goods and new services, e.g., DVD’s and cell phones
- Process Innovations refer to the development of new technologies for producing goods or new ways of delivering services, e.g., robotics and CAD/CAM technology.
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RADICAL (disruptive) VS INCREMENTAL (gradual) INNOVATIONS (often PRODUCT):
- Technological breakthrough that might create new markets
- Small adjustments over existing products
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DRASTIC VS NON-DRASTIC INNOVATIONS (PROCESS)
- Drastic innovations have such great cost savings that they permit the innovator to price as an unconstrained monopolist
- Non-drastic innovations give the innovator a cost advantage but not unconstrained monopoly power
Schumpeter Mark I
It refers to the paleo-schumpeterian entrepreneur. The individual is capable to transform an invention into an innovation through an entrepreneurial act. The main actor of innovation is the entrepreneur.
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Incentive: more than just economics but economics play a very important role:
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- Expectation of supra normal profit of key importance. Be the “first” (and only) in the market increases these expectations.
- Absence of these extra-profits as a pay-off of innovative entrepreneurial activity = low innovation rate.
- If instantaneous imitation = no innovation.
- In order to stimulate innovation, there should not be instantaneous imitation (Patents do play a role on this, even if Schumpeter never put a strong emphasis on IPR protection).
- Over time the “entrepreneurial profit” of the innovator is eroded by competition from imitators.
- The process of “creative destruction”: competition through innovation results in high level of dynamic efficiency (and high social mobility).
—> INNOVATION MAINLY FROM NEW FIRMS
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EXTRA:
It refers to the paleo-schumpeterian entrepreneur. The individual is capable to transform an invention into an innovation through an entrepreneurial act. The main actor of innovation is the entrepreneur.
He is a person with peculiar characteristics that wants to create innovation with not only economic purpose but also an objective of realizing its personality. Economics play a role in the expectation of supra normal profit arising from being the first in the market.
If there is no extra-profit as a pay-off of innovative activities, the innovation rate is low. If economy does not allow the entrepreneur to gain extra-profit, the economy would reach a lower rate of innovation.
However, the extra-profit generated by innovation leads to imitation. Over time, the entrepreneurial rent of the innovator is eroded by competition from imitators. There is a need of patents and intellectual property rights regulation in order to stimulate innovation.
The higher the number of entrepreneurs in the economy, the higher the dynamic efficiency. It is the process of creative destruction, which means competition through innovation results in high level of dynamic efficiency. Innovation comes mostly from small enterprises, new firms and entrepreneurs in general.
Schumpeter mark II
The neo-schumpeterian vision:
Capitalism, socialism and democracy (1942)
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- High innovative performance of the capitalist system, characterized by the presence of large oligopolistic companies which has reduced innovation to “routine” with no need of “leadership”:
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Key role of large scale techno-structures (R&D labs) in the innovative process: R&D benefits from economies of scale.
Capital market imperfections for new firms
—> INNOVATION MAINLY FROM BIG COMPANIES (IN CONCENTRATED MARKETS)
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EXTRA:
It refers to the neo-schumpeterian vision (1942). It was the period of high innovative performance of the capitalist system, characterized by the presence of large oligopolistic companies. Big companies were really gaining momentum in that period and the R&D process became a routine. Therefore, large companies were in a good position to perform R&D and innovation benefitting from economies of scale. He understood that new firms were suffering increasingly from market imperfections and they did not have the funds to perform R&D. Thus, in concentrated markets, innovation comes mainly from big companies.
Since Schumpeter the debate revolves around: PUBLIC POLICY, INNOVATION, MARKET STRUCTURE
Three questions about Schumpeter theories:
1) Which is the market structure favoring innovation?
2) How much should innovation affect market structure?
3) Does public policy have a role in the innovative process?
1° Question: Which market structure favors innovation?
1° Question: Which market structure favors innovation?
“Monopoly deadweight loss is the price that must be paid for high level of innovative activity” (see Geroski 1990, Oxford Economic Papers, 42, p. 586)
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Anticipated and Actual Monopoly Power
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Anticipated monopoly power refers to an innovator’s ability to enjoy the full benefits of its research by preventing imitation (SM1)
Actual monopoly refers to the current monopoly positon of a firm. This position can have positive direct (and also indirect) effects on innovative activity (SM2):
“[…] Monopolists may be possessors of various types of material advantages. In particular, high current period profits generated by the exercise of actual monopoly power may enable a monopolist to hire more highly qualified personnel, and may provide internal finance which facilitates a rapid response to events and weakens the firm’s reliance on costly external finance.” (Geroski 1990, p. 587)
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Arrow (1962) vs. Schumpeter (1942):
Monopoly provides less incentive to innovate than competitive industry because of the “Replacement Effect”.
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Views are not necessarily at odds: incentives to invest in R&D can be different from capabilities to do so.
Mixed evidence:
- inverted U-relationship between intensity of competition and innovation
- radical innovation introduced by new firms (SM1)
- incremental innovation more by large companies (SM2)
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EXTRA:
There are two different views: Schumpeter vs Arrow. The Arrow’s view is that the more a market is perfectly competitive, the more there will be innovation in the market. The process innovation will cannibalize the profit gained by the monopolist. Before innovation, the monopolist was already gaining some profits, so the profit coming from innovation is replacing something already existing. Therefore, monopoly provides less incentive to innovate than competitive industry because of the replacement effect.
The two views may be compatible: incentives to invest in R&D may be superior the more market are competitive but this does not mean that companies in perfectly competitive markets will be able to invest (lower margins, more market imperfections…). Incentives to invest in R&D are different from capabilities to do so.
The relation between intensity of competition and innovation rate has an inverted U shape. It depends on the type of innovation we are dealing with. Therefore, new firms introduce radical innovation and large companies introduce incremental innovation.
2) How much should innovation affect market structure?
Appropriability: ability of the innovator to capture the benefits engendered by its own innovation (to the detriment of other potential imitating firms).
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Appropriability instruments:
a) Obtained exogenously through regulation of property rights: to the innovator is assigned the right to exclude others to make unauthorized use of the innovation (temporary monopoly).
b) Obtained endogenously by an innovative firm through the establishment of strategic barriers to imitation.
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Practical problems of patents:
- Diffusion of valuable information (spillovers) relating to the technology
- Inventing around
- “Contractual” incompleteness and difficult enforcement.
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Main alternative strategic mechanisms to assure appropriability:
- Secrecy (e.g. Coca Cola formula; or see this scene from the movie Flash of Genius: https://www.youtube.com/watch?v=IKMELT29qL4);
- Lead time (Intel microprocessor)
- Complementary investments (in brand, sales & distribution and customer care, e.g. Nespresso).
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Extra:
We have to introduce the concept of appropriability: in order to create a treasure (innovation) there should be a mechanism that allows the innovator to get the most of it. The mechanisms are:
a. Exogenous instruments (intellectual property rights and patents): through regulation of property rights, the innovator gets the right to exclude others to use the innovation without authorization.
The patent is the right to use on an exclusive basis the innovation. The company have to pay some fees on a regular basis. There are some requisites needed to get a patent: there are subjects eligible for patents, the invention should be new, no obvious (not trivial), and devoted to an industrial use (commercial interest).
b. Endogenous instruments (imposed by innovator itself): secrecy, lead time (being always ahead of competitors), complementary investments to protect innovation (brand, advertisig….
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Often patents are not effective because not always a technology is easy to codify: when you ask for a patent, you have to fill a form explaining the technology. It is not easy to translate the physical technology on paper. Moreover, patent means to diffuse innovation: there are information externalities spread in the business world. Other firms may invent around this information coming out with something similar. It is a problem of reverse engineering to create a sort of substitute for innovation. It is difficult and very expensive to demonstrate that other companies have infringed the patent.
Historically, there were two different views on the use of exogenous instruments:
Historically, 2 different views on patent rationale, their lenght, breadth and enforcement:
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Incentives View: they grant a monopoly power but they are necessary to ensure dynamic efficiency.
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Openness View: they create balance between dynamic and static efficiency.
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This debate has been historically solved much more in favor of the incentives view rather than the openness view. However, the openness view is gaining momentum because the number of patents is increasingly growing and patents are no more used with a defensive purpose but with an aggressive attitude.
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Extra:
I patent because I do not want other firms to innovate. Patents together with network externalities create a lock-in effect where innovation is based on cumulativeness and interconnectedness of knowledge. This leads to monopolistic power especially when innovation is based on cumulativeness. Lock-in means that all consumers are locked-in a specific technology (ex. Pc software). Therefore, we had a boom of the number of patents with an exponential trend, even if they are only one instrument to defend innovation.
The Cohen, Nelson and Walsh’s study on appropriability tools demonstrated that firms do
not consider patents so effective in protecting their own innovation.
PATENT might not be used to defend own innovation but rather for preventing others from innovate
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Patent might be used in order to prevent others from innovate: they are dangerous in terms of dynamic efficiency. Technology is very complex and the number of patents on the same product is increasingly growing. This is the patent thicket phenomenon. It is impossible for one firm to have all the patents. Thus, having a patent on a specific and key component
- blocks the others innovation and
- give more bargaining power in a licensing transaction. (what Jaffe e Lerner (2004) define as “Rembrandts in the Attic”)
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References
Cabral, Introduction to Industrial Organization (2000), I edition, chapter 16 and/or Introduction to Industrial Organization (2018), II edition, chapter 15
Further reading:
Comino, Manenti, Industrial Organization of High-technology markets, chapter 6.
Pepall, Richards, Norman, Industrial Organization: contemporary theory and empirical applications, chapter 18.
EXTRA: 3) Does public policy have a role in the innovative process?
Yes, It has a role in patents system and a wider role. The innovative activity in economy is strongly influenced by several forces: competition policy, regulatory and law regimes, patent system. They all contribute to shape the interested dynamic, without forgetting the role of the institutional and cultural context. The public policy has a role in two areas:
EXTRA: Spillovers
Spillovers lead to a global under provision of R&D expenditures. The primary output of R&D investments is the knowledge of how to make new goods and services, and this knowledge is not rival-use by one firm does not preclude its use by another. To the extent that knowledge cannot be kept secret, the firms undertaking the investment cannot appropriate the returns to the investment in it, and therefore such firms will be reluctant to invest, leading to the under provision of R&D investments in the economy.
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The argument relies on the stylized fact that any formal and informal mechanism to protect innovation is only partly efficient at the very best.
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There are some critiques to the spillover: the existence of spillover is generally accepted but it does not justify a policy intervention. The vision is that a firm reduces R&D investments to prevent spillover from another firm but this has an impact on the profit of the other firm. Therefore, the sum of R&D expenditures from both the companies will be lower if one firm decides to reduce the investment.
