T4.

Innovation

1. Innovation And Productivity

Remember: we are trying to understand what causes productivity change. We have discarded firm
size as a causal factor. One obvious candidate are innovations, understood as upwards shifts of the
production function.

How does innovation take place?

- Innovation is sometimes considered to be ‘random’, result of pure luck but its not.
- Since at least the 1970s economics has seriously studied innovation activities as the result of
a production function of its own: firms devote resources to innovate and obtain some kind of
result from it.

Then, the questions about innovation and productivity refer to the details of that ‘innovation
production function’:

- Are innovation outcomes guaranteed or uncertain?

- Are there policies that can improve it? Which?
- Which external (to the firm) factors can influence innovation activities?
- In particular: a more ‘competitive’ (of competition) market environment will encourage or
discourage innovation activities?

DEFINITIONS

Innovation (innovative process):

- Product innovation: new goods or services

- Process innovation: better way of doing things.

Research: investment activity, carrying out research

- Basic research: no evident goal in terms of applications. Something that increases the level of
knowledge without an obvious or immediate application.
- Applied research: application of basic research.

This creates a `problem of what should be financed by the public sector. A solution is that the public
sector can finance the basic research and then firms would carry out the applications.

Development: outcome of research activities in terms of innovation. Implementation as a market

model, something that can be put in the market.

Wrap-up term: R&D (Research and Development)

TWO RELEVANT FEATURES OF R&D

a) Uncertainty.

Any creative process is, by definition, uncertain.

- Ex ante: how a particular project may turn out, or cost, is unknown. Before we engage in the
project, we don’t know how costly and long is going to be.
- Ex post: the practical or commercial application of a new idea is uncertain.

Thus, innovation is a risky process: expected returns > expected costs. Uncertainty reduces incentives
of risk averse firms to carry out R&D
b) Positive Externalities

Innovation activities generate positive externalities, of two different kinds:

- Input spillovers: R&D efforts of one firm help rivals reach their own research goals.
o Published scientific papers
o Information about what is being tried and what is not.
- Output spillovers: first discoverers are not able to collect all of the economic profit generated
by their innovation.
o Once created, knowledge has a public good character: non-rivalry in consumption and
non excludability.
o Different applications may be developed by firms other than the innovator.

Both types of spillovers reduce the incentives of firms to innovate ; private investment in R&D is lower
than the socially optimum level.

INTERNALIZING POSITIVE EXTERNALITIES

Solution to the externalities problem: make pollutants pay (negative) & allow firms to benefit from
the spillovers (positive)

The patent system is a policy mechanism to help firms internalise the spillovers: during a certain period
of time, they hold monopoly rights to recover the investment.

However, what should be the optimal length of a patent is under intense debate.

- In traditional or static sectors not, much is lost by awarding long patents.

- But in dynamic sectors, a long patent can be an important brake for the next innovation
(health)

What about uncertainty? Subsidies & information to reduce risk aversion.

2. Innovation and Market Competition

Are monopolies a way to encourage investment in R&D? Or, alternatively, is competition what creates
incentives to innovate?

Different views, exemplified by the ‘two Schumpeter’:

- Schumpeter (1934): Comes up with the idea that new small firms will come with new
technology and the incentive of expanding the market. The main idea is: promote rivalry and
u will have more information.
- Schumpeter (1943): poor static market performance (large firms that are able to hold price
above marginal cost for extended periods of time) may be a small price to pay for good
dynamic market performance (a cornucopia of new products, produce ever more efficiently).
o Larger firms are able to spread fixed cost of research over a larger sale base.
o Larger firms may have advantages in financial markets.
o Larger firms may be better able to exploit economies of scale and scope in research.
o The serendipity effect: a large, diversified firm is more likely to be able to exploit an
unexpected discovery.
ARROW: COMPETITION ELUSION EFFECT

Arrow’s model provides a simple framework where the

relationship between competition and innovation can be
understood.

The previous example shows that firms in a perfectly

competitive market have more incentives to innovate than
monopolies. So, it seems that more competition is good for
innovation.

But things will get much more complex if we relax some of

the simplifying assumptions of the model:

- Economies of scope and multiproduct firms.

- Risk of innovation failure and firms’ ability to cope
with it
- Reaction time of rival companies (how long can
innovations be protected?)
- Oligopolistic markets
- Different types of innovations may react to
competition in different ways.

A NON-LINEAR RELATIONSHIP BETWEEN COMPETITION AND INNOVATION

Empirical work shows that the relationship is that of an inverted U:

- At low levels of competition, more competition increases innovation.

- At higher levels, more competition decreases innovation.

Aghion et al (2005) provide empirical evidence using patents as measure of innovation.

THEORY (VIVES, 2008)

The effect of competition of innovation depends on the innovation type:

- Process innovations: reduce production costs.

- Product innovations: expand demand. The level of total demand expands when you produce
new varieties.

Vives builds an oligopoly model where product innovations imply introducing new varieties in the
market, based on the following profit function:

𝜋𝑖 [𝑝𝑖 − 𝑐(𝑧𝑖 )] ∗ 𝑆 ∗ 𝐷𝑖 (𝑝; ζ) − 𝑧𝑖 − 𝐹

where a firm’s profits (πi ) from selling a product (variety) i depend on:

pi: price ci: marginal cost F: firm’s fixed costs (entry costs) S= size of the market

zi: investment in cost reduction (process innovation)

ζ: other factors affecting individual demand (Di), which in turn depend on:

- number of product varieties in the market (n) (product innovation)

- degree of substitutability between varieties (σ)
In this model, the firms’ incentives to carry out each type of innovation depend on the profits they
would make from them:

- Profits from process innovations depend on per-firm output: the value of reducing costs
increases with output produced by the firm (the number of units I sell)
- Profits from product innovation depend on the profits that the firm obtains from launching a
new variety of the product.

The competition pressure faced by the firm can increase in three ways:

- Higher substitutability between products (σ): consumers see rivals’ product as closer
substitutes.
- Lower fixed entry costs (F): entry of new firms will be easier.
- Larger market size (S): will attract a larger number of firms.

The equilibrium results of the model show how changes in each exogenous variable (σ, F, S) affects
the incentives of the firm to invest in each innovation type: process and product.

More product substitutability (σ) (increasing competition) results in:

→ Less product innovation: The rewards from introducing new products are lower when rival
products are closer substitutes.
→ More process innovation: Incentives to reduce costs on existing products are higher.

Larger market size (S) (increasing competition) results in:

→ Unclear effects on product innovation: market size increases profits on each variety, but
also intensifies rivalry between firms.
→ More process innovation: As market size increases, the number of firms increases but less
than proportionally. So, per firm output increases. This provides more incentives for cost
reduction. On average, the units sold per firm are higher because the number of varieties
won’t increase as much as consumers.

Higher entry costs (F) (decreasing competition) result in:

→ Less product innovation: with less firms, there are lower incentives to differentiate by
introducing new varieties.
→ More process innovation: with less firms, per-firm output increases. Then, investments in
cost reduction are more profitable.

Therefore, the impacts of competition on innovation are not simple: they depend on the way in which
competition changes and the type of innovation we look at. But we can test these theoretical
conclusions with an empirical model.
3. Empirical Analysis (Beneito et al, 2015)
They test the implications of Vives (2008) model using Spanish data.

Survey of Business Strategies (Encuesta de Estrategias Empresariales)

- Very detailed data on firms’ characteristics and strategies.

- Annual data since 1990. Here they use 1990-2006.
- Very rich dataset: firm coverage, stability, detailed questionnaire.

Firms in the survey report if they have carried out product and/or process innovations in the previous
year.

Other replies in the survey make it possible to build variables that measure the competition-intensity
variables: σ, F, S.

Large firms are more likely to innovate (57% vs 32%).

- Product (38% vs 17%)

- Process (48% vs 23%)

For large firms both types of innovations are not independent: they more likely to do both process
and product innovations. They have a higher ability to carry out innovation of both types.

Beneito et al (2015) build measures of competitive pressure following Vives’ model:

- Product substitutability: demand elasticity is not observed, but can be indirectly measured
from advertising intensity: σ. The higher the substitutability the higher the expenditure on
marketing.
- Market size: firms in the sample declare if their market is expanding (ExM). Also, indirect
calculation of market size (sizeM) and tariffs (τ). They ask question to approximate X (ex. Level
of tariffs).
- Entry costs: Set-up costs (output share divided by capital/output ratio), fixed and marginal
R&D costs in the industry (FRD, MRD) for given sectors.

The econometric model:

- Dependent variables: product & process innovations [discrete related decisions: estimation
as a ‘bivariate probit’ which means a (0,1) choice (not OLS)] the error terms are not
independent.
- Independent variables: competition measures + market characteristics.

Main results are consistent with the theoretical predictions of Vives (2008):

- More product substitutability increases process and decreases product innovations.

- Larger market size has the same positive impact on both innovation measures.
- Higher entry costs reduce incentives to innovate in products but increase them on process
innovations.