Voluntary Lecture – Innovation Ec930

1. Voluntary Lecture – Innovation Ec930 Spring 2014

2. Outline • Product Market Structure and the Incentives to Innovate • Historical review of Neoclassical Research: Questions and Results • Product Market Structure and the Incentive to Innovate: • Innovating to escape competition: replacement effects and efficiency gains of innovation • Innovating to preserve monopoly: strategic innovation to exclude competitors • Competition and Innovativeness: An Inverted U Relationship • The composition effect

3. Introduction We will start with an historical discussion of neoclassicists’ view of the interaction between innovation and market structure, some measurement issues and some empirical results. We will see from these results that there is no conclusive empirical link between market structure and the amount of innovation that goes on. As a result, we will then move to theory and will see that there are, indeed, forces that would tend to favour innovation in highly competitive markets as well as forces that would favour innovation in highly monopolised markets (or, at least, innovation by incumbents rather than new entrants). When these counter-acting forces are embedded in a growth model, one can see an “inverted U” relationship between market structure and innovation, with moderately competitive markets generating the highest innovation rates.

4. Literature on Innovation and Market Structure: Questions and Results (see Cohen and Levin, 1989) Schumpeter, 1942: “The atomistic firm in a competitive market is the suitable vehicle for static resource allocation, but the large firm operating in a concentrated market is ‘the most powerful engine of progress and… long run expansion of output…perfect competition…has no title to being set up as a model of ideal efficiency’” Why might this be true? (Schumpeter) • Firms require an expectation of some form of (transient) market power to have the incentive to invest in R&D 2. An oligopolistic market structure and market power ex ante make rival behaviour more predictable and thereby reduce uncertainty associated with innovative effort. 3. Large firms might not be as financially constrained as small firms

5. This view of large firms and concentrated markets as engines of growth sets static efficiency losses against dynamic efficiency gains. • Some static resource misallocation costs estimates are miniscule (0.07% GNP, Harberger, 1954), some substantial (4-13% GNP, Cowling & Mueller, 1978) • Even the largest of these might be worth incurring in exchange for larger rates of technological progress, if we believe the numbers from growth literature on the contribution of technology to growth, see Solow’s classic articles, for example, or more recent work. (i.e. the dynamic efficiency gains might justify static efficiency losses) • This view is in contrast to antitrust orthodoxy, which came into its own in the early 20th century with the establishment of basic anti-trust statutes.

6. This view sparks a literature that tests two hypotheses: • Innovation increases more than proportionately with firm size • Innovation increases with market concentration Overall, however, both the empirical and theoretical literature on this has been inconclusive. (See Cohen and Levinthal, 1989)

7. This is partly due to measurement problems: • How do we measure innovativeness? -input-based measures: R&D personnel? R&D expenditure? Non-R&D based innovation (learning economies?) -output-based measures: Patent or Innovation counts? Weights? • Endogeneity problems: - size  innovativeness or innovativeness  size? - concentration  innovativeness? or innovativeness  concentration? 3. What if large firms purchase smaller firms or their innovations? How do we count these? What if small firms are spin-offs from large firms?

8. Scherer(1967) finds an “inverted U” relationship between product market concentration and R&D intensity with a “four firm concentration ratio” of 50-55 being “best” i.e.: Market share leader + market share next biggest + market share next biggest + market share next biggest = 50-55%...for example… 20% + 15% + 8% + 7% = 50% (and the rest of firms are smaller) When the effect of technology class is compared to the effect of market structure, however, technology class appears far more important determinant of innovativeness. Kamien and Schwartz(1976) suggest that firms may be able to reduce R&D costs by pursuing longer lived development strategies, but at the expense of increasing the probability a rival will invent first. More intense R&D rivalry will elicit greater R&D, but will eventually cause innovative activity to decline. Hence, there is an “inverted U” relationship between R&D competition and aggregate R&D activity.

9. Schmookler (1962) suggests that demand conditions (size of market, price elasticity, rate of growth, number of competitors) and supply conditions (technology class and stage in technology cycle, for example) jointly determine innovativeness, but recognises that spillovers and regulatory environment will also affect innovativeness

10. Product Market Structure And the Incentives to Innovate Let’s go back to theory and see where the ambiguity may come from… “What market structures are most conducive to innovation?” (based on Schumpeter’s work) Easiest way to isolate the strategic effects: ask first “How do a monopolist’s incentives to innovate compare to a perfect competitor’s?” Consider a single firm’s incentive to invest in cost reduction when the alternative toinnovation is no innovation by any firm Assume: homogeneous goods constant marginal (and average) cost

11. Price Monopoly profit: P.C. profit: 0 PM MC PC=P’ Demand 0 Quantity QM QC MR Price Monopoly profit P.C. profit: 0 PC MC Demand Quantity 0 MR QM QC

12. Price PM PM’ MC PC=P’ MC’ Incremental: old technology constrains pricing Demand 0 Quantity MR Price PC MC PM’ Drastic: old technology does not constrain new pricing at all. Demand MC’ Quantity 0 MR

13. - Price Monopoly gain: P.C. gain: - 0 PM PM’ MC PC=P’ Gain loss MC’ Incremental Demand 0 Quantity MR - Price Monopoly gain: P.C. gain: - 0 PC MC Gain loss PM’ Drastic Demand MC’ Quantity 0 MR

14. In the case of drastic innovation, the monopoly gains to innovation clearly are less than the perfect competitor’s gains. In the case of incremental innovation, it is a bit less clear from the graph, but it can be shown that the perfect competitor’s gains exceed those of the monopolist as well. Intuition: The new process takes away the profits generated by the old process and replaces them with new profits. For the monopolist, this represents a real loss. The perfect competitor, however, was earning zero profits with the old process, hence there is nothing to “replace”. For both the monopolist and the perfect competitor, there is a gain due to the lower marginal cost (efficiency gain). For the perfect competitor, this is a pure gain, whereas for the monopolist, this gain needs to be tempered by the fact that a replacement occurs. This leads to a smaller net gain for the monopolist…hence the incentive to innovate is to “escape competition”

15. Note: Cohen and Levinthal observed higher innovation rates associated with higher levels of competition. Policy Issue: Should we reduce concentration in the product market in order to correct the incentives to innovate? This has implications for competition policy: it suggests that we should not have a different policy towards monopolisation practices in (potentially) innovative markets. Management Issue: The current leader would normally expect not to maintain this position because of reluctance to “cannibalise” …and this may be (privately) optimal

16. But an alternative argument goes the other way… We have assumed that there is no competition in the market for innovation: innovations “fall into the lap” of a single firm. Consider the incentives of a single firm to invest in innovation when the alternative to innovation is that another firm innovates: in other words, the innovation market is now competitive! Which type of firm, an incumbent monopolist or a new entrant, will have a greater incentive to innovate? In monetary terms, which type of firm would “bid” more in order to achieve the rights to an innovation? Assume that we have: two firms, a single incumbent and an entrant. the innovation lowers cost from marginal and average cost of ch to cl. homogeneous products

17. Outsider/entrant bid: Πd(cl,ch) – 0, where the first term reads “duopoly profit with own cost lower than competitor’s cost” Insider/incumbent bid: ΠM(cl) – Πd(ch,cl), where the first term reads “monopoly profit at the lower cost level” and the second reads “duopoly profit with a cost level higher than the competitor’s” Which of these “bids” is larger? ΠM(cl) – Πd(ch,cl) ? Πd(cl,ch) – 0  ΠM(cl) ? Πd(cl,ch) + Πd(ch,cl) … “insider bid” “outsider bid”

18. Outsider/entrant bid: Πd(cl,ch) – 0, where the first term reads “duopoly profit with own cost lower than competitor’s cost” Insider/incumbent bid: ΠM(cl) – Πd(ch,cl), where the first term reads “monopoly profit at the lower cost level” and the second reads “duopoly profit with a cost level higher than the competitor’s” Which of these “bids” is larger? ΠM(cl) – Πd(ch,cl) ? Πd(cl,ch) – 0  ΠM(cl) ? Πd(cl,ch) + Πd(ch,cl) … In other words, is monopoly profit by a low-cost firm greater or less than industry profit, when the industry is composed of two competitors, one of which has high cost? In most models, the monopolised—and efficient– industry would make more money

19. Outsider/entrant bid: Πd(cl,ch) – 0, where the first term reads “duopoly profit with own cost lower than competitor’s cost” Insider/incumbent bid: ΠM(cl) – Πd(ch,cl), where the first term reads “monopoly profit at the lower cost level” and the second reads “duopoly profit with a cost level higher than the competitor’s” Which of these “bids” is larger? ΠM(cl) – Πd(ch,cl) > Πd(cl,ch) – 0  ΠM(cl) > Πd(cl,ch) + Πd(ch,cl) … In other words, is monopoly profit by a low-cost firm greater or less than industry profit, when the industry is composed of two competitors, one of which has high cost? In most models, the monopolised—and efficient– industry would make more money. So “insider” outbids “outsider” .

20. Interpretation: The monopolist/incumbent firm has a greater strategic incentive to obtain new innovations in order to preserve a favourable industry structure. Policy Issue: Reduce barriers to entry into the research/innovation market – but not the product market – in order to preserve the incentive to innovate for incumbent firms. Keep product markets concentrated? The incumbent’s incentive to innovate here may be so strong that it results in socially excessive innovation: For example Suppose the innovation does not lower cost (cl = ch)…it just allows another method of obtaining the same cost level, hence allowing entry. Which firm has a greater incentive to obtain, patent, and hold this innovation? ΠM(ch) – Πd(ch,ch) ? Πd(ch,ch) – 0  ΠM(ch) ? Πd(ch,ch) + Πd(ch,ch) “insider bid” “outsider bid”

21. Interpretation: The monopolist/incumbent firm has a greater strategic incentive to obtain new innovations in order to preserve a favourable industry structure. Policy Issue: Reduce barriers to entry into the research/innovation market – but not the product market – in order to preserve the incentive to innovate for incumbent firms. Keep product markets concentrated? The incumbent’s incentive to innovate here may be so strong that it results in socially excessive innovation: For example Suppose the innovation does not lower cost (cl = ch)…it just allows another method of obtaining the same cost level, hence allowing entry. Which firm has a greater incentive to obtain, patent, and hold this innovation? ΠM(ch) – Πd(ch,ch) ? Πd(ch,ch) – 0  ΠM(ch) > Πd(ch,ch) + Πd(ch,ch)

22. Interpretation: The monopolist/incumbent firm has a greater strategic incentive to obtain new innovations in order to preserve a favourable industry structure. Policy Issue: Reduce barriers to entry into the research/innovation market – but not the product market – in order to preserve the incentive to innovate for incumbent firms. Keep product markets concentrated? The incumbent’s incentive to innovate here may be so strong that it results in socially excessive innovation: For example Suppose the innovation does not lower cost (cl = ch)…it just allows another method of obtaining the same cost level, hence allowing entry. Which firm has a greater incentive to obtain, patent, and hold this innovation? ΠM(ch) – Πd(ch,ch) ? Πd(ch,ch) – 0  ΠM(ch) > Πd(ch,ch) + Πd(ch,ch) In most competitive models, the incumbent would still have the greater incentive to obtain the innovation, even if it was not used (as it does not, in fact, lower cost at all).

23. This sort of innovation (merely to preserve a favourable industry structure, with no final improvement in cost or product) is socially wasteful, hence there are some cases where firms are not allowed to take out “sleeping” patents (patents that will not be put to use). Empirical Issue: We should observe “persistence of monopoly” rather than “leapfrogging”. In fact, we observe persistence sometimes and leapfrogging at other industries/times. Why?

24. Persistence of Monopoly in Bertrand Markets Vickers(1986) Assume: Homogeneous products constant marginal and average cost Bertrand Competition Main characteristics of Bertrand competition? • price competition (with no capacity constraints, usually) • Aggressive pricing resulting from ease with which can steal customers away from competitors • With at least two firms, outcomes are perfectly competitive (profits are zero, prices fall to marginal cost when all firms have the same marginal cost level) • If one firm has a higher cost level, the lower cost firm can use this as a price “umbrella”: by pricing just under the high cost firm’s cost, the low cost firm can serve all market demand and earn positive profit.

25. Price ch Ph cl Demand 0 Quantity Q High cost firm cannot price below Ph. Low cost firm can price at or slightly below Ph and steal all customers, selling Q units and obtaining profits of

26. Let: ch > cm > cl. Both firms start at ch.

27. Price ch cm cl Demand 0 Quantity Q

28. Let: ch > cm > cl. Both firms start at ch. Each firm bids in each period to be the exclusive owner of the technology that lowers cost frontier one “step”. Hence, the period 1 winner will have cm, while the competitor retains ch. The second period winner will have cost cl. Let A and B bid in period 1. Both will bid Πd(cm,ch) – 0. Say we arbitrarily choose A to be the winner. In period 2, then, we have an asymmetric industry structure: firm A has marginal cost cm and firm B has marginal cost ch. Bids in period 2: A bids: Πd(cl,ch) – 0 B bids Πd(cl,cm) – 0 Which is bigger? (In other words, does a single firm have the incentive to develop all innovations or will the firms exchange “winner” role?)

29. Price Bids in period 2 ch Ph cm cl Demand 0 Quantity Q Q’ High cost firm cannot price below its cost level (cm or ch). The winner in period 2 has cost cl. Πd(cl,ch) = Which is bigger? Πd(cl,cm) =

30. Let: ch > cm > cl. Both firms start at ch. Each firm bids in each period to be the exclusive owner of the technology that lowers cost one “step”. Hence, the period 1 winner will have cm, while the competitor retains ch. The second period winner will have cost cl. Let A and B bid in period 1. Both will bid Πd(cm,ch) – 0. Say we arbitrarily choose A to be the winner. In period 2, then, we have an asymmetric industry structure: firm A has marginal cost cm and firm B has marginal cost ch. Bids in period 2: A bids: Πd(cl,ch) – 0 B bids Πd(cl,cm) – 0 Which is bigger? The looser price umbrella yields the higher profit, making A’s bid higher. Hence, the winner in period 1 tends to have a greater incentive to win in period 1 to “escape competition”

31. Leapfrogging or Persistence in Cournot Markets Assume: Homogeneous goods Constant marginal and average costs, ch > cm > cl (as before) Cournot Competition Main Characteristics of Cournot Competition: • As firms produce to capacity, there is unaggressive response to changes in capacity because market share is hard to steal. In fact, the larger my capacity, the less incentive you have to set a high capacity because market prices will be lower, all else equal. • Price adjusts to clear the market • Cournot competition will generate positive profits for industry participants. These decrease as the number of firms rises because each firm sets its own output target not taking into account the negative externality this has on the rival’s profits. This is true even for a high cost firm.

32. Period 1 bids: Both firms bid Πd(cm,ch) – Πd(ch,cm). As before, we suppose that firm A wins Period 2 bids: A bids: Πd(cl,ch) – Πd(cm,cl) B bids: Πd(cl,cm) – Πd(ch,cl) Which is bigger? Πd(cl,ch) – Πd(cm,cl) ? Πd(cl,cm) – Πd(ch,cl)  “period 1 winner bid” “leapfrogger bid”

33. Period 1 bids: Both firms bid Πd(cm,ch) – Πd(ch,cm). As before, we suppose that firm A wins Period 2 bids: A bids: Πd(cl,ch) – Πd(cm,cl) B bids: Πd(cl,cm) – Πd(ch,cl) Which is bigger? Πd(cl,ch) – Πd(cm,cl) ? Πd(cl,cm) – Πd(ch,cl)  Πd(cl,ch) + Πd(ch,cl) ? Πd(cl,cm) + Πd(cm,cl) … in other words… Are industry profits greater when we have more asymmetric costs or more similar costs? In fact, the answer depends on the specific demand and costs assumed.

34. For example: Let P = 1-Q Q = Qa + Qb for firms “a” and “b” Then industry profits are: (cl, ch) … [(1-2cl+ch)/3]2 + [(1-2ch+cl)/3]2 (cl, cm) … [(1-2cl+cm)/3]2 + [(1-2cm+cl)/3]2 Let cl = 0. If cm = .4 and ch = .5 we have: (cl,ch) > (cl,cm) Let cl = 0. If cm = .1 and ch = .2 we have: (cl,ch) < (cl,cm) Hence, we can have either result, depending on whether the initial costs are relatively high (where the benefit of reaching the frontier with a huge lead is large) versus the case where initial costs are relatively low (where the benefit of making the follower much more efficient dominates)

35. Notes: • In some industries (pharmaceuticals) we tend to see increasing dominance (in some classes of drugs) but leapfrogging in other (classes), so that even at the industry level it is hard to generalise. What can we say about patterns of innovation, then? Cournot-type behaviour tends to be more common in economic upturns (as capacity constraints become binding) whereas Bertrand-like behaviour tends to be observed more in downturns. Hence, the pattern of leadership we should observe may vary over the economic cycle -- if innovation decisions occur in a short enough interval to adjust to this sort of change in behaviour. Otherwise, we would expect that the pattern of change in leadership would reflect the dominant oligopoly model for the industry.

36. Competitiveness and Innovation: an Inverted-U Relationship (see Aghion, Bloom, Blundell, Griffith, Howitt, 2002) Assume: Process Innovation (marginal cost lowering) Innovation is step-by-step (must pull even before can pull ahead) Imitation is such that can be at most one step behind Profitability depends on lead (so if one step ahead, earn more than if tied with the other firm) • As soon as you are a leader (ie, one step ahead) there is no further benefit to innovating because you can never pull more than one step ahead. Further, the follower must “win twice” in order to become a leader. This combination reduces innovation incentives in an “asymmetric industry” …mutes “strategic/Schumpeterian incentive” • If you are tied with leader (“neck-and-neck”), there is a strong incentive to pull ahead, as there is a big benefit to leading and it takes only one step to become a leader. This combination raises innovation incentives in a “neck-and-neck” industry: “escape competition” effect

37. lower product market concentration means lower profits in neck-and-neck industries, which lowers the payoff to not innovating and hence RAISES the innovation incentives “escape competition motive rises” AND lower product market concentration means lower profits to followers in asymmetric industries in the transition state of pulling even with the leader, hence lowering the payoff after innovation and so LOWERING innovation incentives. “Schumpeterian reward motive falls” • Whether an increase in product market competition leads to more or less innovation IN THE ECONOMY depends on the distribution of firms across neck-and-neck and asymmetric industries as well as the incentives within each of these industries. “composition effect”

38. N N A A N N N A A A A N N A A A N A A A A A A A A A A A Period 1 Period 2 Period 3 Period 4

39. BUT When there is very high product market concentration (i.e. little product market competition), the neck-and-neck sectors are very stable (as their innovation rate is low), whereas the asymmetric sectors are relatively unstable (as their innovation rate is high) Hence, most sectors in the economy will become “neck-and-neck” so that the aggregate innovation rate becomes low.

40. N N A A N N N N N N N N N N A N N N N N N N N N N N N N Period 1 Period 2 Period 3 Period 4

41. BUT When there is very high product market concentration (i.e. little product market competition) the neck-and-neck sectors are very stable (as their innovation rate is low), whereas the asymmetric sectors are relatively unstable (as their innovation rate is high) Hence, most sectors in the economy will become “neck-and-neck” so that the aggregate innovation rate becomes low. As we lower product market concentration (i.e. raise product market competition), the neck-and-neck sectors become more unstable (because their innovation rates rise) whereas the asymmetric sectors are relatively stable (as their innovation rates fall). Hence, most sectors will become asymmetric when product market competition is very high and aggregate innovation rate is low.

42. There is an intermediate range where there is a mix of sectors and innovation rates are relatively large in both. This is the most productive state, as it turns out.

43. High Economy’s Innovative- ness Low Low Product market competition high Hence, the “inverted U” relation is the result of the “Schumpeterian” and “escape competition” effects combined with the “composition” effect. This relation survives numerous complications of the model. They test this on UK companies, 1968-1997. Using citation-weighted patents as their measure of innovativeness and price-cost margins (“Lerner index”) as a measure of product market competition. They find support for inverted U’s in a wide variety of industries and with variety of alternative measures.

44. chemicals Motor vehicles Industry innovative- ness Low “PMC” High Low “PMC” High Food, Beverages, tobacco Industry Innovative- ness Electrical & electronics Low “PMC” High Low “PMC” High (PMC is “Product market competition”).

45. Innov. Neck-and-neck industries All firms PMC

46. 4. Kortum, Lerner (1999) Note recent surge in patenting (“innovativeness”) Patent Apps In Japan Patent Apps In Europe & US US Ger. Jap. UK Fra. 1955 1965 1975 1985 1993

47. Why? Test hypotheses: Friendly Court Hypothesis: Changes in US court system in 1982 were main cause? (Should see mainly jump in US by all applicants) Fertile technology hypothesis: New technologies, new financial intermediaries, applications of information technology, shift to more applied research focus in firms is main cause? (Should see mainly larger applications in fertile technology classes. May see jump worldwide if technological “opportunity” is evenly spread.) Regulatory Capture hypothesis: Changes in court were result of lobbying by subset of US players who are benefiting from it? (Should see surge in patents concentrated in a few – US – players.) Results: General worldwide increase across patent classes and players is not consistent with either friendly court or regulatory capture hypotheses. Further, it is not consistent with opportunities driven by few patent classes. Rather, appears to be result of “improved” management of innovation process itself across a wide variety of fields.

48. Summary • The proposition that innovation is linked to firms size and industry concentration has generated a large literature due to its anti- trust implications. • Theoretical effects and empirical evidence combine to suggest that moderate concentration levels generate the most innovative economies. • Other work supports opening up markets as a means of spurring innovation. • However, the process of changing concentration levels can affect innovation as well. • Some studies question the magnitude of product market competition effects compared to those of government industrial policy and management techniques. Perhaps market effects exist, but are relatively modest.

49. Additional References Abramovsky, Jaumandreu, Kremp, Peters (2004), “National Differences in Innovation Behaviour: Facts and Explanations” mimeo. Aghion, Philippe, N. Bloom, R. Blundell, R. Griffith, P. Howitt (2002), “Competition and Innovation: An Inverted U Relationship”, mimeo. Cassiman, Bruno, M. Colombo, P. Garrone, R. Veugelers (2004), “The Impact of M&A on the R&D Process: An Empirical Analysis of the Role of Technological and Market Relatedness”, mimeo. Cohen, Wesley and D. Levinthal (1989) “Innovation and Learning: The Two Faces of R&D” Economic Journal 99(397). 569-596. Gandal, Neil and K. Rockett (1995) “Licensing a Sequence of Innovations”, Economics Letters, 47, pp. 101-107. Kamien, N., N. Schwartz (1976) “Market Structure and Innovation: A Survey”. Quarterly Journal of Economics, 90(2), 245-260. Kortum, Sam, J. Lerner (1999), “What is behind the Recent Surge in Patenting?” Research Policy, 28(1), 1-22.

50. Additional References Reinganum, Jennifer (1983) “Technology Adoption under Imperfect Information”, Bell Journal of Economics, 14, 57-69. Vickers, John (1986) “The Evolution of Market Structure when there is a Sequence of Innovations”, Journal of Industrial Economics, 35(1), pp. 1-12. Vives, Xavier (2004), “Innovation and Competitive Pressure”, CEPR Discussion Paper 4369.