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Topic: Innovation Chapter Six: Technical change, productivity and market structure.

Introduction Introductory Definitions  Technical change in the industrial context can be usefully characterised as having three stages. 1. It is set in motion by invention, which may be based on new scientific knowledge or uses well known scientific principles. 2. The innovation stage occurs when and if the invention is first commercially introduced by a firm, often called the innovator. 3. Then as the new product or process is recognised as superior to competing existing technologies, this results in its further application within the innovating firm and its introduction by other firms in the industry; imitation or diffusion occurs. These three stages establish that technical change is a process stretching through time. New technologies are usually defined as being either process or product innovations. Process innovation is ‘a novel way of making old things”. Product innovation involves “old ways of making novelties”. Two activities in inventive and innovative activity are patenting and research and development expenditure (R&D). o Generally, patents are viewed as an output of inventive activity, and R&D as an input into both the inventive and innovative stages. The research component of R&D might be identified primarily with invention and development with innovation. “The output of the process of advancing technology is technological advance”. A successful innovation will generally be associated with significant cost reductions and, therefore, productivity increases. o Productivity growth will reflect more than just technical change.

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Process of technological change: Inventions are often made as the consequence of research expenditures and results in patents. Following further development expenditures the innovations appear on the commercial scene. At this point, for process innovations at least, best practice productivity has been increased, but it is only with diffusion that actual productivity levels approach the new best practice.  Through the conduct-performance framework, invention and innovation can be identified as elements of industry conduct, measured perhaps by R&D expenditure and output of patented inventions. The effects of conduct are translated through to performance (productivity) via diffusion.

Appropriability of the results of its activity   Any firm engaged in inventive activity will consider potential returns. Uncertainty    There is technical uncertainty as to whether R&D will successfully generate a new technology. sold perhaps by a capital goods producer for example. what sort of demand curve will the new product attract? There is also uncertainty with respect to how rivals react – rivalry uncertainty – will they match ‘our’ R&D programmes.  2. and speeding up development may incur excessively high costs.Some Important Concepts 1. There is the market uncertainty concerning the impact of the technology when it hits the market – by how much will a process innovation reduce costs. . will they attempt to beat us to innovation. Consider the case of a firm with a process innovation in a perfectly competitive market subject to free entry. The moment the new process is introduced. The patent is a governmental device designed to grant the innovator a limited period during which the monopoly profits of innovation may be earned. when.  3. finance and R&D to exploit new technologies quickly. other will imitate. In deciding when to adopt a new process. or for late adoption when troubles have been eradicated? Joseph Schumpeter   Schumpeter put forward the twin ideas that monopoly power and the large scale of the firm were the ideal vehicles for generating technical advance. driving price down to a new lower level and wiping out profits from innovation. development programmes have a significant learning dimension. This is most obvious in the time-cost tradeoff or ‘patents race’ in developing technologies. or will they imitate? Uncertainty must be taken into account for a model to be theoretical model to be taken seriously. o Profits thus act as an incentive to innovate. and if so. Timing    Timing is often crucial. His basic argument in favour of large firms is that they have large scale of production and capacity plus the infrastructure in marketing. should we opt for early adoption to gain a competitive edge over rivals. While there are advantages of being first.

This compares the potential returns to invention of a new process for a using industry which is alternatively competitive or monopolistic. Schumpeter’s theory of technical change and the firm:  Innovation is typically discontinuous and lumpy: “it arises from within the system (and) so displaces its equilibrium point that the new one cannot be reached from the old one by infinitesimal steps. is the product of technical change. he stresses more basic psychological drives such as empire building and the joy of creating. new forms of organisation of an industry – including the creation or breaking up of monopoly position – and stimulate process and product innovation. o The entrepreneur is an innovator rather than a profit maximiser. 196 – 199)  Arrow’s (1962) seminal analysis of the incentives to invent.  The entrepreneur (in Schumpeter’s view) is not the narrow profit maximiser of the neoclassical theory. as well as having greater incentives. Schumpeter also argued that market power.  Fig. Monopoly or imperfect competition provides a better setting in which to exploit. Market structure. The Theory of Invention and Innovation The Incentive to Innovate (Pp. There is not much distinction between invention and innovation.  The inventor’s optimising decision therefore involves maximising rQ with respect to r. Large oligopolistic firms are better able to internalise the benefits of innovation and are generally more certain of their environment. and it compares both with what is socially optimal.1 on page 197 – The incentive to invest Competitive case:  The innovator charges firms (using the innovation/new technology) a royalty. r.  Innovation also includes the opening up of markets. was the reward for innovation – supernormal profits. As an activity such as R&D displays scale economies. . subject to r ≤ pc – C’. below the initial level. C. large firms with large R&D departments will be more efficient in generating innovations. now C’ + r. so there is an incentive to innovate only if one feels confident of being able to exploit that innovation rapidity. this is important because capitalist competition involves rapid imitation with innovations continually superseding each other. the conquest of new sources of materials. 6. Rather. the ability to raise prices above average costs. to some extent. for each unit of output produced using the new technology.  As this leaves their marginal costs.      In Schumpeter’s view of the world. competitive pressures ensure that they all adopt immediately with price falling to p = C’ + r.

in what amounts to a bilateral monopoly problem. but not in the monopoly case since profits were already being made in the preinvention world. πB. Monopolists may thus be less motivated to innovate for the reason that they are able to earn supernormal profits in the first place. his profits will be πB. it follows that. 16. Monopolistic case:  It is now in the inventor’s interest to charge a lump sum rather than a per unit royalty since the latter would cause the monopolist to restrict output which a lump sum payment would avoid this.  Since the monopolist user will price where MR = C’ in the post-invention case. the cost saving is more moderate and the most that the inventor can earn in the competitive case is (C – C’)Qc – this still exceeds the maximum which can be earned in the monopoly case. this must be less than the return he can earn in the competitive case. even under perfect competition.   Even assuming the inventor were able to claim the entire increase in profits. C’C’.and post-invention situations. The key to this result lies in the fact that the inventor is able to extract the fully monopoly profit associated with the lower cost curve in the competitive case. o Fig. it would be optimal for price to be equated to the new lower marginal costs. (p – C’)Q. the private benefit is less than the potential for social benefit.   . 16.  Even with a lump sum levy.e. for the moment. the most the inventor can extract is the user’s increase in profits between pre. the results remain the same. All that changes is that there is no haggling over the shares of the post-invention increase in profits. the inventor can control the product price by varying his royalty charge and his return will be the surplus of using the industry’s sales revenue over its production costs.1b – moderate cost reduction. The solution is shown by r* which generates a return of πB. This would generate an increase in surplus equal to the trapezium CABC’. that is to maximise the sum of producer and consumer surplus. the innovator is able to extract the full monopoly profit from the demand curve and will therefore set r such that industry marginal revenue equals C’. and the increase in profits therefore πB – πA.  In effect. For non-drastic inventions. o Fig.  The above analysis is focused on a drastic invention: once which yields a ‘drastic’ cost reduction that the inventor’s optimising problem is unconstrained with r* < C – C’. that the constant is inoperative. i. Since this exceeds πB. Assuming. If the inventor is a monopolist.1a – significant cost reduction.  Important conclusion regarding the divergence between private and social benefits from the new technology:  If the market were to be socially managed.

experimental approaches may be required. he has nothing to gain by withholding his new technology away from competition since he is able to extract full monopoly profit from the market anyway by choosing an appropriate royalty rate.  If alternatively the inventor is one of the firms in the competitive industry. Scherer (1976) argues that in industries with relatively more.       . at which the curves are parallel and the surplus V – D is maximised. The optimal development period is T*. it follows that the maximum that the inventor can extract from them will be less than under perfect competition. and smaller. The technological scenario is one in which there is a known invention with a number of firms racing to be the first to bring it to the market – ‘patent race’. Early introduction allows the market to be tapped for a longer time. o Parallel. This analysis seems to carry over to oligopoly to the extent that oligopolists are already earning supernormal profits before the invention appears. o More traditional diminishing returns. firms. the returns from the innovation will be higher the more quickly It is introduced to the market. Fig. A crash programme is more costly because: o Errors are made when stages in development overlap instead of waiting for the information emerging from early experiments. 6. However. therefore.2 on page 200 – The time-cost tradeoff   A very rapid development programme will entail much higher R&D costs compared to more leisurely development. and provides the innovator with a competitive edge over rivals and a consequent increased market share which may extend into the longer run if early adoption establishes brand loyalty. 200 – 205)   Arrow ignored the speed of innovation with rivalry among potential innovators. V becomes steeper and lower as market concentration declines. while retaining the notion of a single predetermined invention with known technical characteristics. potentially duplicative. the conjectured advantages of early innovation/the disadvantages of late innovation are more pronounced because firms anticipate greater scope for increased market share at the expense of rivals. Criticisms on pages 198 – 199 The Pace of Development and the Timing of Innovation (Pp. The competitive environment in this model affects the location of the V-curve. overtime premiums may result in each stage of the programme as more resources are used.

  If ‘our’ firm does innovate first. The value of h most conductive to speedy innovation is zero – optimal T increases with h – this can presumably be equated to pure monopoly.       The intensity of competition affects the speed of innovation – hazard parameter. If and when this happens. Turning to the effect of firm size. as in V2. since this increases the chances of being beaten to the market. Scherer’s conclusion is that the more rapid innovation is likely where the number of sellers is greater. large firms will be under pressure to retaliate quickly to protect their market share. The optimal T will be at some intermediate value of h. the monopolist benefits from no market share effect and increased revenues can only result from success in expanding the market and/or extracting a higher price in recognition of improved new product quality. but beyond some lower limit on concentration. and possibly also new entry and price wars. profitable innovation is considered unlikely. Scherer uses the potential of increased market share argument to suggest that there are greater incentives for small firms to innovate rapidly.  The advantage of rapid development is that it increases the chances of being first. in this case. and concentration is lower. whatever the length of the development programme. but if the accompanying inward shift is too severe. For firms already making good profits (perhaps monopolists). that maximises expected profits – this is surplus of expected revenue over development costs. rivals are able to change their own development pace in response. Our firm’s problem is to choose the time period. Lower curves reflect the likelihood of faster imitation in a more competitive environment. the stimulus to innovate may be killed off by fears that a failure to internalise the returns from innovation for very long will prevent development costs from being covered.   On the other hand. the speed of innovation is maximised for firms in industries characterised that have some degree of competition. as in V1. the incentive to innovate is reduced. In the case where innovation speed is maximised under monopoly occurs for new products offering only moderately good returns.  Kamien and Schwartz are able to establish that either: 1. Larger values of the hazard parameter (h) indiciate faster expected rival innovation and can therefore be equated with more intense rivalry. on the other hand. T. Expected profits is derived as the difference between (the present value) of expected revenue and costs. Firms initially making no profits (potential entrants) or for firms contemplating diversification will innovate more rapidly. the expected revenues from the innovation will decline the longer its introduction is delayed. 2. optimal T is thus located where expected marginal revenue equals marginal development costs (MC=MR). . Steeper curves mean faster optimal development.

they will all be frustrated and probably incur losses. and each knowing how much its rivals intend to spend. even though innovation may appear profitable for an individual firm in isolation. the firm begins to fear that it will not get the reward from being the first and will also lose the development costs. so ensuring that it wins the ‘patent race’ and gains the entire profit from innovation. none of the firms will consider it worthwhile to incur R&D expenditures and therefore no innovation will occur.  This argument is where the V-curve lies everywhere below the D-curve. this cannot be an equilibrium since any one of these firms could increase R&D marginally.  If two or more firms were active. how long the development will require one R&D outlays have been decided. Model outlined by Dasgupta and Stiglitz on page 204. However. each investing the same amount.  Magnitude of equilibrium R&D expenditure are larger in industries characterised by greater demand and greater than what is socially optimal. .  Only one firm in the innovative stage does not signal a lack of competition. With intermediate levels of rivalry. o The latter disagrees with Arrow’s original finding who suggests that the threat of potential competition pushes the innovator too fast. if all firms act in this way. If all firms perceive this to be the case ex ante. he is also supposed to be able to predict. Suppose there is an industry of n identical firms each making the development decision simultaneously. innovation sped is identified with highly profitable innovations.  We assume that the potential innovator has perfect information on the future characteristics of his invention before embarking on the development phase. with certainty. the fear of losing the race spurs additional expenditure on development but as the intensity of competition continues to grow. It then reduces investment in development and thereby postpones the planned introduction date”. all would presumably plan to innovate by the same time. Since all firms are identically. This will significantly reduce the returns from the new product and each firm might be tempted to spend a little more than its rivals to ensure being first (on Cournot conjectures). Technical inefficiency (Dasgupta and Stiglitz).   One entrepreneur may be clever than the rest (Kamien and Schwartz).  The only equilibrium is where there is only one firm operating and earning zero profits – a Cournot equilibrium. “Initially.

the expected during of the development phase). 2.Innovation and R&D as a Continuous Activity (Pp.    It is assumed that innovation and R&D are rather more continuous activities.  Greater concentration does not necessarily cause greater research intensity – R&D intensity and firm number will vary between industries as the scope for cost improvements varies. . the technical characteristics of the innovation are known in advance. 205 – 210) We have considered a very limited characterisation of technical change. but the amount done per firm falls. so does the industry’s equilibrium R&D expenditure.  In the case where concentration and research intensity are equal.  As the number of firms increases. independent patents. but less than proportionately. Higher research intensities more likely in less competitive industries (or at least where significant product differentiation exists). with the generalised effects of pushing the firm’s demand curve outwards (for product innovation) or its cost curve downwards (for process innovation). The number of firms in the industry will depend upon entry conditions: 1. and the amount of expenditure on R&D merely determines how quickly the transformation takes place (or with technical uncertainty. and innovation is a continuous. Dasgupta and Stiglitz (1980) – R&D expenditure is directed at process innovation.  Measure the level of concentration by the mark-up of price over cost (Lerner Index). Entry barriers  The number of firms is fixed exogenously and the absence of entry means that. Dorman-Steiner condition for advertising on page 207. not discrete.  Less concentrated industries conduct more R&D than more concentrated ones. the lower is concentration.  If the demand is highly price inelastic. activity. there is no reason to suppose zero profits. o Schumpetarian prediction confirmed. this follows the assumption of free entry. We are now assuming: similar research but with different outputs. It is one in which there is a given single invention and R&D is undertaken in order to develop it into an innovation. Free entry  The number of firms will be just sufficient to ensure zero profits. the market will undertake more R&D than a socially managed economy would. The firm should spend relatively more on R&D the more elastic is demand with respect to R&D expenditure and the less elastic it is wit respect to price.  R&D sales ratio for the industry rises with concentration. in general.

(Empirical Studies of Innovation and Invention on pages 210 – 218) Diffusion    Focus on process innovations (cost-saving process innovations). as opposed to a socially managed economy. the proportion of firms not having adopted the new technology to date who to adopt in a given time period will be critically influenced by the proportion of their competitors who have already adopted. inter-firm diffusion is certainly not instantaneous. o Amount of cost reduction is lower than what is socially optimal.  Schumpetarian Hypothesis – technical change is fostered by monopoly power and large firm size. The diffusion of new technologies is the process by which new innovations spread and come into common usage in industries concerned.  Intra-firm diffusion is instantaneous. Non-adopters tend to revise their attitude towards the new process because as more information and experience accumulate.  The market. Competitive pressures mount and a bandwagon effect occur. may involve excess duplication. A firm or industry with an impressive inventive and/or innovative record may still lag behind its competitors in performance if it fails to diffuse those innovations sufficiently rapidly.  Overall diffusion will therefore reflect the aggregate usage of the technology. Example – cost-saving process innovation for the weaving industry  The diffusion process commences with the first adoption by a weaving firm and it proceeds as further weavers adopt and as those who have already adopted to process innovation use it more widely in their operations. development speed may be maximised by intermediate degrees of rivalry. Cost reductions are lower is less concentrated industries – greater industry expenditures merely reflects more repetition. Inter-Firm Diffusion   Once diffusion is under way. it becomes less of a risk to begin using (the new process).  Market structure and innovation are jointly determined.  For all process innovations. Summary:  Market structure and R&D will be jointly determined.  Kamien and Schwartz – development speed will be greatest under monopoly for new products with moderately high returns. .  The market structure and technical change relationship Is highly sensitive to the ways in which innovative activity is modelled.  Dasgupta and Stiglitz – for major innovations.

Also. Mansfield (1961) argues that the value of β will reflect the characteristics of the innovation and of the industry in which it is diffusion. the cost disafvantage of a non-adopter may not result in any loss of market share in industries characterised by price fixing.e an industry where firms are not equal sized).           . The mere fact that a large proportion of competitors have introduced it may prompt a firm to consider it more favourably. 6. he does suggest that β should be higher.e. He suggests that β will be large (diffusion will be faster) the greater is the profitability (π) of the innovation and the smaller is the relative size of the investment outlay required to install it. price leadership. While Mansfield does not develop a strong theoretical case for expecting concentration to affect diffusion speeds. The firm compared the expected payback period with some target payback period to make its decision. o Β is referred to as the speed of diffusion. This is a rejection of the Schumpetarian hypothesis. If one assumes that the process innovation is cost saving. meaning that he cannot offer any reasons on why some firms adopt early. Fig. However. More costly innovations are viewed as more risky. Diffusion speed (β) is thus lower in more concentrated industries. collusion. ceteris paribus. oligopoly). the technology itself is refined and improved as a result of learning. Manfield only models the behaviour of firms in aggregate. the profitability of adoption varies between firms due to technical reasons. β tends to be higher in industries with a larger number of firms (competitive markets) and lower in industries with a larger variance of logarithm of firms size (i.4 on page 220 – Logistic/cumulative normal diffusion   The steepness of the curve is determined by the value of β. o Larger firms will tend to apply more liberal targets as the consequences of potential failure are relatively less significant than for small firms. Davies (1979) model states that firm size is an important characteristic in deciding whether or not to adopt the new process. price reductions on the part of adopters (passing costs savings onto consumers via lower prices) will have little effect on the market shares of non-adopters. and others late. Process innovations typically involve scale economies – expected profitability of the technology is typically higher for large firms. or in the kinked demand curve (i. larger values of β yielding steeper curves and thus more rapid diffusion. in markets which are more competitive – this derives from the ‘competitive pressures’ argument mentioned previously. Expectations are likely to improve over time because information becomes clearer – non-adopters observe the successful application of new technology by their competitors. In industries with highly differentiated products.

The market structure of the supplying industry. the degree of learning economies. o Firm size is a positive (in fact the only) determinant of diffusion speed. o Unfortunately. it is impossible to establish whether increased firm number will increase or retard diffusion. in principle. Mansfield suggests that the larger tend to adopt earlier because: o They are better able to bear the costs and risks. and the extent of any financial constraints can be important influences on the diffusion path. o The overall effect of concentration is unclear.        Why Do Some Firms Adopt Earlier than Others?    Davies suggested that large firms will tend to adopt more quickly. The earlier adoption by large firms. including scale economies in the application of the new process. Reinganum suggests that the effects of strategic behaviour emanating from oligopolistic rivalry may be. Davies agrees with Mansfield in that the profitability of innovation has a positive effect on diffusion speed. This equilibrium involves an orderly sequence of adoption. o They are likely to encompass a wider range of operating conditions than smaller firms. as some innovations have only limited applicability initially – there is greater likelihood that large firms will have the appropriate condition for adoption of the new innovation in its early years. Reinganum (1981) suggested that Nash equilibrium of adoption dates will exist due to the assumptions that the profitability of adoption is greatest for early adopters but the costs of adjustment involved in quick adoption are higher. in this model. the pace of which is sesnsitive to the number of firms (concentration). but not monotonically. Note. is determined by the magnitude of factors such as the pace of learning. just as important as imperfect information and/or heterogeneity of potential adopters in understand the mechanics of diffusion. The speed of diffusion. Diffusion may be slower in industries with more firms perhaps because information dissemination is slower. there will always be some firms who will adopt more rapidly than large firms. o There is a greater probability of large firms needing to replace old equipment at any point in time. improvements in information and any other time variant determined of the expected and target payback period. . Market structure will influence diffusion speed. the objectives of the firms in that industry. Mansfield (1963) findings suggested that the size of the firm was a negatively significant determinant.   The target payback period tends to increase over time because firms assess favourably the risk adoption. again on the basis of the experience of others.

presumably because of the lower risk attached as time passed. and often caused by. the expectation that successful innovation will lead to a monopoly position induces firms to invest in R&D. technological change. Increased R&D activity has been shown to follow increases in profitability. The speed of intra-firm diffusion is found to depend positively and significantly on the profitability of the new technology. Fig. and the favourable experiences of others was observed. Profits accumulated through the exercise of monopoly power are a key source of funds to support costly and risky innovation. The date of first adoption result implies that firms who adopted relatively later ten proceeded to catch up by conducting faster intra-firm diffusion. The possession of monopoly power is conductive to innovation in the kind of turbulent environment associated with. The chain of causation is said to run from existing market structure to the pace of innovation.2 on page 631  Neither patents nor being first with a new product are normally sufficient to exclude competitive imitation. .   (Productivity and Market Structure on pages 228 – 236) Scherer and Ross The Links Between Market Structure and Innovation      Under the logic of the patent grant. o The results on profitability and liquidity are as expected. Over time. The surplus being made is more formally referred to as quasi rent. the date of its first adoption but insignificantly on the size of the firm. o Intra-firm diffusion takes place or not depending on what is learnt. though it must be recognised at once that there are feedback effects from innovation to market structure. 17. the firm’s liquidity. No gains can be realised until R&D is completed and the product is commercially introduced. the firm learns about the characteristics of the new technology from its own experiences.Intra-Firm Diffusion   Firms learn from their own experience to successively discount the risk associated with the new technology. Monopoly and Oligopolistic Rivalry    Introducing a product innovation is viewed as tapping into a market with some potential for earning profits.

the longer it will have to wait to tap the stream of potential quasi rents. 2. o The steeper the slope. the representative firm’s discount quasi-rents function is not only steeper.           . and potentially other related market – and thus a share of its rival’s quasi rent. o The imitator. Moving on to design and production steps before early experiments have yielded their information saves time but increases the number of false starts. Conventional diminishing marginal returns in allocating talent to a given technical assignment. o An increase in the number of symmetric rivals accelerates product R&D. distribution channels. The longer the firm takes to carry out its development. An asymmetric model shows a tendency for market-dominating firms to be slow in developing important new but. firms would reduce their high R&D costs and give up some market share in compensation. the more curvature the time-cost tradeoff function is likely to have. and the more heavily discounted the benefits it anticipates will be. the firm must find a development schedule that leaves the maximum vertical distance between the quasi rent function and the R&D cost function. Fig. the quasi-rents of the innovator begin to fall (rival firms get some of the surplus gains). To maximise profits. As the number of would-be innovators increases to some critical value N. the stronger the innovator’s first-mover advantage. One may have to pursue parallel experimental approaches to find a good solution quickly under uncertainty. will capture only a smaller share of the quasi rents. increases the cost of R&D for three reasons: 1. the steeper a representative firm’s discounted quasi-tent function V will be. The more symmetric firms there are. A small firm would gain more from being first than a large firm. the quicker is the profit maximising R&D schedule. but lies at all points below the time-cost tradeoff function. The more uncertain the technological environment is. “roar back like tigers” when smaller rivals – often new entrants – challenge their dominance. 17. 3. First-mover advantage permits one firm to capture more or less permanently a specific share of the market – due to building up a well established reputation. Maximum profits (surplus over R&D costs) are achieved in a monopolistic market structure – a case where no imitation is possible due to a lack of competition.3 on page 633 – Time-cost tradeoff function  Accelerating the pace of R&D – achieving lower values of T (introduction date). The longer the imitator delays his product introduction. If losses were being made.  When a rival firm begin to imitate the product innovation. in this case.

the discounted total quasi rent function is above the time-cost tradeoff function. Competition is characterised by free entry. 17. but also be price competition has eroded the market’s profitability. the ability of firms to hold prices at monopoly level will break down. Dynamics and Welfare Implications  The profitability of innovation depends upon demand and supply conditions. it is assumed to provide its owner perfect protection. meaning that expected profits (after covering fixed R&D costs) are zero.     If R&D is to be undertaken at all. the market will be divided up into so many segments that each firm’s discount quasi rents are too small to cover R&D costs. Advances in knowledge and increases in demand have the potential of making previously unrealistic innovations now feasible. But it is not profitable. When that happens. As the market structure moves from monopoly to duopoly to looser oligopoly. it will be done quickly. as a result of changes in knowledge and/or demand. there is a yearly cost of carrying the development loan. it can make a (greater) profit. o Demand: changes in the income of the population – demand pull innovations. Once a patent is granted. A monopolist is in a secure position such that it can wait until the profit maximising moment to innovate. Also. the quasi rents per firm will be too small to cover R&D costs not only because the new product market is divided into so many segments. Increased fragmentation stimulates more rapid and intense support of R&D. it is financed by taking out a loan. As knowledge accumulates. . the time-cost tradeoff function (Fig. o Supply: changes in the costs incurred due to scientific and knowledge advances – technology push innovations.          Fig. o The monopolist will not wait forever because early profits are preferred to later profits. there will be market failure. An innovation becomes profitable when. so if firms correctly see what is happening. 17. Any competition is at the pre-innovation stage since a patent permits a monopoly to determine the price of the innovation.3) shifts towards the origin. because if it waits. A profit maximising monopolist would not innovate today if it anticipates a further fall in development costs.6 on page 639 When development is carried out. o Pure competitors are thus motivated to innovate sooner than a secure monopolist. Each firm will refrain from investing in R&D in the expectation that if all invest.

the less rich an industry’s technological opportunities are. The Role of Market Concentration (Industry level)  In a modern economy.  The Evidence  Market structures can affect the pace of innovation. Previously. enhance the buying industry’s productivity. If the cost per firm of conducting R&D is small relative to the size of appropriable quasi rents. generating large quasi rent opportunities for the taking. and materials which. and in many cases. many firms will join in. A positive and statistically significant correlation was found between productivity growth and seller concentration ratios. we discussed that more rivalry – lower concentration – invigorates R&D spending up to a point.      . some firms recognise an opportunity more quickly than others. o Some industries specialise in producing technologically advanced machines.Further Theoretical Insights       Most industries experience a continuing stream of innovations over time. and a zero profit equilibrium will emerge. but innovation in turn can shape market structure. A zero profit result is more convincing when there are more firms with relevant capabilities that the quasi rent potential can accommodate. but the number will be large enough to again drive profits to zero. Multi seller rivalry is more appropriate to stimulate R&D quickly and unexpectedly. With a dynamic world (changing technological knowledge base and demand conditions). each complete new product or process innovation sets an agenda focusing on improvement work for the next technological generation. when purchased by other industries. components. Most studies suggest a positive relationship between concentration and industry R&D /sales ratio. when the pace of technological advance is slow and continuous. Barzel’s competitive case: zero profits emerged due to aggressive firm’s preemption of potential rivals before they started their own R&D efforts. We expect R&D/sales ratios to be more strongly (positive) correlated with seller concentration ratios. there will be a few participants. Firms are driven by the probability of success – a high probability of success will increase the R&D efforts. If the project costs are large relative to quasi rents. there are strong interrelationships among industries. and the first movers characteristically gain advantages that prevent imitators from driving the industry to a symmetric zero profit equilibrium. o However. a zero profit outcome is not very convincing.

Their size permits them to maintain a diversified portfolio of R&D projects. o A high market concentration was more likely to retard innovation than stimulate it. o Such activities permit them to penetrate markets more rapidly and effectively with new products. Large firms can attract capital at a lower cost than smaller firms and may therefore be better able to finance ambitious R&D undertakings. have much greater power in explaining varying R&D or innovation intensities than differences in such market structure indices such as concentration. A large laboratory can justify purchasing highly specialised equipment. however measured.         . If innovation stimulates the entry of new competitors. concentration will tend to fall in high-opportunity industries. minimising the fringe firms’ lead or even pre-empting them. Highly concentrated industries were the result of aggressive innovation and patents (and/or other barriers to imitation).     The Advantages of Large and Small Firms (Firm level)  Firms with relatively small or (for new entrants) zero market shares have incentives to force the innovative pace when they anticipate gaining first mover advantages and capturing substantial chunks of market share. Innovation could be concentration increasing if successful innovators rise to market dominance and defend themselves successfully from imitators. Large firms tend to have well established marketing channels and may realise scale economies in advertising and other promotional activities. The ability to exploit scale economies is another potential advantage. However. It can employ specialists in many disciplines. and the expectation of those higher margins had a positive influence on innovation – Monopoly favoured innovation. A conclusion that arises from every study is that interindustry differences in technological opportunity. o May accrue to other parts of the large firm’s operations. hedging the risks that any given project will fail. dominant firms subjected to such threats are motivated to respond aggressively. Geroski discovered that greater monopoly power led to larger time lagged profit margins. enhancing profitability. Large companies have noteworthy advantages in supporting research and innovation. o Entry rates are much higher during the early life cycle sages of major product innovation.

There is a greater chance of disagreement within larger firms – conflict of ideas/inability to get ideas approved can result in creative individuals leaving the firm! Large firms tend to be unwilling to take on risks or accepting ‘change’. the threat of entry through innovation by a newcomer can stimulate existing members to pursue well-know technical possibilities more aggressively. with the role of monopolistic elements diminishing when rich technological opportunities arise. o Such activities require extensive resources. Small firms seem to be “leading the way” with respect to developing innovative processes. . On the other hand. Patents are only issued to successful innovations. in a large firm. Small firms tended to do well in industries with rapid technical progress. o Large firms can often undertake the tasks of technical development. Sometimes. Technical progress thrives best in an environment that nurtures a diversity of sizes and. Their decisions to go ahead with an ambitious project are typically made by a handful of people who know each other well. The resources of large firms play a significant role in turning ideas into reality. the decision must filter through a complex chain of command. however. Large firms did well in industries where concentration was high and advertising and capital-intensive production were present. a suitable blend of competition and monopoly is required. Smaller firms (or potential entrants) are more willing to innovate but entry barriers imposed by incumbents prevent this. For rapid technical progress. that keeps barriers to entry (by technologically innovative newcomers) low. Large firms have less to gain from innovating first. perhaps especially. may be more suitable for risk taking.       Small firms.     Conclusions (page 660)    Monopolies (high concentration) tend to retard technological progress by restricting the number of independent sources of initiative and dampening firms’ incentive to gain market share through accelerated R&D.