Research and Development

1
Research and Development
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Introduction

• Technical progress is the source of rising living
  standards over time
• Introduces new concept of efficiency
• Static efficiencytraditional allocation of
  resources to produce existing goods and services
  so as to maximize surplus and minimize
  deadweight loss
• Dynamic efficiencycreation of new goods and
  services to raise potential surplus over time
• Schumpeterian hypotheses (conflict between static
  and dynamic efficiency)
• Concentrated industries do more research and
  development of new goods and services, i.e., are
  more dynamically efficient, than competitively
  structured industries
• Large firms do more research development than
  small firms

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A Taxonomy of Innovations

• Product versus Process Innovations
• Product Innovations refer to the creation of new
  goods and new services, e.g., DVDs, PDAs, 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
• We mainly focus on process or cost-savings
  innovations but the lines of distinction are
  blurreda new product can be the means of
  implementing a new process
• Drastic versus Non-Drastic Innovations
• Process innovations have two further categories
• 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
  adavantage but not unconstrained monopoly power

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Drastic versus Non-Drastic Innovations

• Suppose that demand is given by P 120 Q and
  all firms have constant marginal cost of c 80
• Let one firm have innovation that lowers cost to
  cM 20
• This is a Drastic innovation. Why?
• Marginal Revenue curve for monopolist is MR
  120 2Q
• If cM 20, optimal monopoly output is QM 70
  and PM 70
• Innovator can charge optimal monopoly price (70)
  and still undercut rivals whose unit cost is 80
• If cost fell only to 60, innovation is
  Non-drastic
• Marginal Revenue curve again is MR 120 2Q
• Optimal Monopoly output and price QM 30 PM
  90
• However, innovator cannot charge 90 because
  rivals have unit cost of 80 and could under
  price it
• Innovator cannot act as an unconstrained
  monopolist
• Best innovator can do is to set price of 80 (or
  just under) and supply all 40 units demanded.

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Drastic vs. Non-Drastic Innovations (cont.)
NonDrastic Innovation QM lt QC so innovator
cannot charge monopoly price PM because rivals
can undercut that price
Drastic Innovation QM gt QC so innovator can
charge monopoly price PM without constraint

• Innovation is drastic if monopoly output QM at MR
  new marginal c exceeds the competitive output
  QC at old marginal cost c

/unit p
/unit p
PM
c
c
PM
c
Demand
Demand
c
MR
MR
Quantity
Quantity
QC
QM
QC
QM
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Innovation and Market Structure

• Arrows (1962) analysis
• Innovative activity likely to be too little
  because innovators consider only monopoly profit
  that the innovation brings and not the additional
  consumer surplus
• Monopoly provides less incentive to innovate that
  competitive industry because of the Replacement
  Effect
• Assume demand is P 120 Q MC 80. Q is
  initially 40. Innovator lowers cost to 60 and
  can sell all 40 units at P 80.
• Profit Gain is 800Less than Social Gain

/unit
Initial Surplus is Yellow Triangle--Social Gains
from Innovation are Areas A (800) and B
(200) But Innovator Only Considers Profit Area A
(800)
120
80
B
A
60
Quantity
40
60
120
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Innovation and Market Structure (cont.)

• Now consider innovation when market structure is
  monopoly
• Initially, the monopolist produces where MC MR
  80 at Q 20 and P 100, and earns profit
  (Area C) of 400
• Innovation allows monopolist to produce where MC
  MR 60 at Q 30 and P 90 and earn profit
  of 900
• But this is a gain of only 500 over initial
  profit due to Replacement Effectnew profits
  destroy old profits

/unit
Monopolist Initially Earns Profit CWith
Innovation it Earns Profit ANet Profit Gain is
Area A Area C Which is Less than the Gain to a
Competitive Firm
120
100
C
90
A
80
60
Demand
MR
Quantity
20
60
120
30
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Innovation and Market Structure (cont.)

• Preserving Monopoly Profit--the Efficiency Effect
• Previous Result would be different if monopolist
  had to worry about entrant using innovation
• Assume Cournot competition and that entrant can
  only enter if it has lower cost, i.e., if it uses
  the innovation
• If Monopolist uses innovation, entrant cannot
  enter and monopolist earns 900 in profit
• If Monopolist does not use innovation, entrant
  can enter as low-cost firm in a duopoly
• Entrant earns profit of 711
• Incumbent earns profit of 44
• Gain from innovation now is no longer 900 - 400
  500 but 900 - 44 856
• Monopolist always has more to gain from
  innovation than does entrantthis is the
  Efficiency Effect

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Competition and Innovation

• The incumbent/entrant model just discussed seems
  closer in spirit to Schumpeters ideas than
  Arrows analysis.
• Dasgupta and Stiglitz (1980) come even closer by
  directly embedding innovation in a model of
  Cournot competition
• Profit for each firm ??i P(Q) c(xi)qi xi
• Here, firms unit cost falls as the firm engages
  in RD activity
• What is the equilibrium?
• Define x as the optimal RD level of each firm
• From Chapter 9, we know that

• But with n symmetric firms si 1/n, So we have

Output Condition
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Competition and Innovation (cont.)

• How much should x be?
• The usual marginal calculations apply. Every
  increase in x costs 1. The benefit is the cost
  reduction this brings, ?c(x)/?x, times the
  number of units q to which this cost reduction
  will apply

RD Condition
Both the Output Condition and the RD Condition
must hold simultaneously in any equilibrium
One obvious implication of the RD Condition is
that the R D effort of any one firm will
fall as the number of n firms increases
because this will decrease the output of
each firm
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Competition and Innovation (cont.)

• Making n endogenous means allowing firms to enter
  until they no longer have an incentive to do so
• This will occur when firms earn zero profit after
  allowing for RD costs. Defining n as the
  equilibrium number of firms, the Output Condition
  then implies

• Substitution into the RD Condition then yields

Industry RD as Share of Sales

• Industry RD effort declines as n rise, i.e.,
  as industry becomes less concentratedfairly
  strong theoretical support for Schumpeterian
  Hypothesis

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Competition and Innovation (cont.)

• But empirical support for Schumpeterian view is
  mixed
• Need to control for science-based sectors (e.g.,
  chemicals, pharmaceuticals, and electronics) and
  non-technology based sectors (e.g., restaurants
  and hair stylists)RD much more likely in
  science-based sectors regardless of firm size
• Need also to distinguish between RD expenditures
  and true innovations. Common finding e.g.,
  Cohen and Klepper (1996), is that large firms do
  somewhat more RD but achieve less real
  innovative breakthroughse.g., Apple produced the
  first PC
• Market structure is endogenous. Innovations
  might create industry giants (e.g., Alcoa) not
  the other way around.
• Bottom Line Validity of Schumpeterian
  hypotheses is still undetermined

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RD Spillovers and Cooperative RD

• Technological break-throughs by one firm often
  spill over to other firms
• Spillover is unlikely to be complete but likely
  to arise to some extent
• We can model this in the Dasgupta Stiglitz world
  by now writing a firms unit cost as a function
  of both its own and its rivals RD
• c1 c x1 - ?x2
• c2 c x2 - ?x1
• To obtain solution, need also to assume that RD
  is now subject to diminishing returns, i.e., RD
  cost is r(x) x2/2.
• In this setting, response of firm 1s RD to
  firm 2s RD depends on size of spillover term ?.
• When ? is small, RD expenditures are strategic
  substitutesthe more firm 1 does the less firm 2
  will do
• When ?? is large, RD expenditures are strategic
  complementsthe more firm 1 does the more firm 2
  will do

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RD Spillovers and Cooperative RD (cont.)

• However, determination of whether RD efforts are
  strategic substitutes or strategic complements is
  not sufficient to determine what happens when
  there are spillovers
• Let Demand be given by P A BQ
• Let ci c xi ??xj
• Each firm now chooses both production qi and
  research intensity xi

• To make things simple, suppose that A 100, B
  2 and that firms have to choose between setting
  x at either 7.5 or 10

• Now consider two cases
• First case Low Spillovers ? 0.25
• Second case High Spillovers ? 0.75

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RD Spillovers and Cooperative RD (cont.)
Nash Equilibrium is for both firms to choose the
high level of research intensity (x 10). Why?
When degree of spillovers ? is small, firm know
that if its rival can do RD knowing that it will
get most of the benefits. Since this would
advantage the rival, each firm tries to avoid
being left behind by doing lots of RD
The Pay-Off Matrix for ? 0.25
Firm 1
High Research Intensity
Low Research Intensity
Low Research Intensity
107.31, 107.31
100.54, 110.50
Firm 2
High Research Intensity
110.50, 100.54
103.13, 103.13
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RD Spillovers and Cooperative RD (cont.)
Nash Equilibrium is for both firms to choose the
low level of research intensity (x 7.5). Why?
When degree of spillovers ? is large, firm knows
that it will benefit from technical advance of
its rival even if it doesnt do any RD itself.
So, each firm tries to free-ride off its rival
and each does little RD
The Pay-Off Matrix for ? 0.75
Firm 1
High Research Intensity
Low Research Intensity
Low Research Intensity
128.67, 128.671,
136.13, 125.78
Firm 2
High Research Intensity
125.78, 136.13
133.68, 133.68
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RD Spillovers and Cooperative RD (cont.)

• MORAL of the foregoing analysis is that the
  Outcome of non-cooperative RD spending depends
  critically on the extent of spillovers.
• What if RD spending is cooperative?
• RD cooperation can take two forms
• 1. Do RD independently but choose x1 and x2
  jointly to maximize combined profits, given
  competition in product market is maintained.
• 2. Do RD together as one firm, e.g, form a
  Research Joint Venture. That is, effectively
  operate as though the degree of spillovers is ?
  1, again though, continue to maintain product
  market competition.
• The two types have very different implications.

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RD Spillovers and Cooperative RD (cont.)

• Consider first the case of coordinated but not
  centralized RD using our generalized demand and
  cost equations
• Total RD spending now rises unambiguously as ?
  increases.
• To see this note that given our earlier demand
  and cost assumptions, and given the fact that x1
  and x2 are chosen to maximize joint profits, the
  optimal values for x1 and x2 are

This is unambiguously increasing in ? but this
is a good news/bad news story.
The good news is that for the high spillover
case (? gt1), the free- riding problem is no
longer an issue and firms now do more RD
The bad news is that for the low spillover case
(?? lt 1), there is no longer a fear of being left
behind by ones rival. So in this case firms do
less RD which means costs (and consumer prices)
are higher.
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RD Spillovers and Cooperative RD (cont.)

• What about a Research Joint Venture?
• As noted, this effectively changes ? to 1.
• For our general demand and cost equations, it can
  be shown that

This is clearly more RD than occurred with
simple coordination for any given value of ?
As a result, it leads to lower costs and more
output to the benefit of consumers
Profits are also higher. Thus, in the presence
of spillovers, Research Joint Ventures are
unambiguously beneficial. The only trick is
to make sure that cooperation is limited to
research and does not spill over to other
dimensions of competition