Industrial Organisation

Seminar 7 Innovation and Technological Change

1. Explain the distinction between the basic research, applied research, development,
commercial production and diffusion stages in the commercial application of a new
technology.
Basic Research
- Basic research corresponds to the invention stage in the Schumpeterian trichotomy. At
its extreme, basic research may be carried out without any practical application in
view.
- For example, early research in molecular physics was carried out without any
foreknowledge of the use of the valve in broadcasting and communications.
- Industrial firms may be reluctant to undertake basic research, due to the uncertainty of
outcome. Consequently, basic research is often the province of government agencies
and universities.
- In a study of the petroleum and chemical industries, Mansfield (1969) finds only about
9 per cent of the firms total research and development expenditure was on basic
research, while 45 per cent was on applied research and 46 per cent on development.
Applied Research
- Applied research has a stated objective. Following an investigation of the potential
economic returns, research is under- taken to determine the technological feasibility of
the proposed application.
Development
- Generally this can be considered as the bringing of an idea or invention to the stage of
commercial production. At this stage, resources are heavily committed, and pilot
plants or prototypes may have to be built. Although it is clear that at every stage of
research and development the firm must review its progress, it is at the development
stage that the selection process for the next (commercial production) stage is most
important. The failure of a new product that has already entered into commercial
production would be very costly to the organization.
Commercial Production
- This stage refers to the full-scale production of a new product or application of a new
process. Regardless of the amount of research and development already undertaken,
there is still a large element of risk and uncertainty. A major difference between
invention and innovation arises from the level of risk involved: the main interest of the
inventor is in the generation of ideas and not the production of goods and services on a
commercial basis. Together, the applied research, development and commercial
production stages correspond to the innovation stage in the Schumpeterian trichotomy.
Diffusion
- The final stage refers to the spread of the new idea through the firm, as well as the
imitation and adoption of the innovation by other firms in the same industry, or in
other industries where the innovation may be applicable. There is also a spatial
element to the diffusion process, as ideas spread geographically through foreign direct
investment, licensing agreements or joint ventures.

An important distinction is often drawn between product and process innovation. A product
innovation involves the introduction of a new product. A process innovation involves the
introduction of a new piece of cost-saving technology. However, the distinction between
product and process innovation is not always clear cut. New products often require new
methods of production; and new production processes often alter the characteristics of the
final product. Furthermore, one firms product innovation may be another firms process
innovation. For example, a new piece of capital equipment might be classed as product
innovation by the producing firm; but from the point of view of the user, the machine would
represent a process innovation.
2. Is the level of effort devoted to research and development likely to be any higher if an
industry is monopolised than if it is perfectly competitive? Consider this with reference to the
debate between Arrow and Demsetz.
Monopoly
- In favour of monopoly, one can point out that firms in highly concentrated industries
may earn abnormal profits, which can be invested in risky research and development
programmes. Firms in more highly competitive industries may earn only a normal
profit, leaving no uncommitted resources available to finance speculative investment
in research and development.
- Furthermore, the lack of competitive pressure in a monopoly creates an environment
of security, within which it is possible for the firm to undertake high-risk investment in
projects whose returns may be uncertain at the outset.
- In the event that the investment succeeds, there is less risk of imitation; and in the
event that the project fails, there are no rivals waiting to step in and take advantage of
the firms temporary financial difficulties (for example, by initiating a price war at a
time when the firms ability to sustain losses might be diminished).
- In other words, the lack of competitive pressure gives the firm the time and space it
needs to develop and grow.
Perfectly Competitive
- In the absence of competitive pressure, the managers of a monopoly firm might tend
to become complacent or lazy; or excessive internal bureaucracy within the firms
organizational structures might lead to a loss of managerial control, or other forms of
technical inefficiency (x-inefficiency).
- Another line of reasoning suggests the probability of a successful product or process
invention emerging is positively related to the number of research teams that are
simultaneously working on similar a idea or challenge. Under a competitive market
structure, there may be more research teams competing to be the first to come up with
a solution, and therefore a higher probability that at least one of these teams will
succeed.
- Finally, a monopolist that owes its market power to a successful innovation in the past
may be so tied to its existing technology that to switch resources to a new product or
process would be considered too costly. A slightly more subtle variant of this final
argument in favour of competition points out that if a new piece of technology
displaces a monopoly firms current technology, the monopolists incentive to innovate
is governed by the net effect on its profit. Under a competitive market structure, the
incentive to innovate is governed by the gross return from the innovation.
Accordingly, the incentive to innovate may be greater under competitive conditions
than it is under a monopoly.

Arrow (1962)
- Arrow compares the impact of a cost-saving process innovation under market
structures of perfect competition and monopoly. In both cases, constant returns to
scale and horizontal LRAC and LRMC (long-run average and marginal cost) functions
are assumed. The innovation causes a downward shift in the position of the LRAC
(=LRMC) function. Under perfect competition, it is assumed the inventor charges each
perfectly competitive firm a royalty per unit of output for use of the cost-saving
technology.
- The inventors return is the total value of the competitive firms royalty payments.
Under monopoly, it is assumed the monopoly firm itself is the inventor. The inventors
return is the increase in abnormal (or monopoly) profit realized due to the adoption of
the cost- saving technology.
- Concludes that the incentive to invent or innovate is greater under perfect competition
than it is under monopoly.

Demsetz (1969)
- Because the pre-innovation output levels of the perfectly competitive industry and the
monopoly are different, Arrow fails to compare like with like. Arrows comparison
tends to favour the perfectly competitive industry because the benefits of the costsaving technology are spread over a larger volume of output than in the monopoly
case.
- In order to make a fair comparison, we should set aside the usual tendency for a
monopolist to produce less output than a perfectly competitive industry. Instead, the

comparison should be based on an assumption that the pre-innovation output levels are
the same under both market structures.

In other contributions to the ArrowDemsetz debate, Kamien and Schwartz (1970)

argue that a fair comparison between the incentives to invent and innovate under
perfect competition and monopoly should be based on a starting position at which not
only the industry output levels, but also the price elasticities of demand, are the same.
This is not the case in Figure 14.3: the monopolists demand function (DM) at (P1,
Q1) is more price elastic than the perfectly competitive industrys market demand
function (DC) at (P3, Q1). In an analysis that assumes identical preinnovation output
levels and price elasticities, Kamien and Schwartz show the incentive to innovate is
stronger under monopoly than it is under perfect competition.
Yamey (1970) observes Arrows analysis focuses solely on a cost-saving innovation.
Therefore Arrow does not con- sider the case of a completely new innovation, which
allows production of a good that was previously either uneconomic or technologically
infeasible. In this case, the assumed pre-innovation output level under both market
structures is the same: zero. With zero pre-innovation output, the incentive to innovate
is identical under perfect competition and monopoly.

3. What factors are relevant to a firm in determining the speed at which it intends to execute a
planned research and development programme? Why might the market structure in which the
firm operates be relevant in this decision?
Demand
- Perhaps the most fundamental issue is whether the new idea meets an unsatisfied
market demand. This is not always as difficult as it may sound, since in some cases it
may be customers who alert their suppliers to a gap in the market. For example,
Minkes and Foxall (1982) find that a large proportion of research and development is
stimulated by requests for product or process improvement from users.
Costs
- Given that the full costs of development projects are often uncertain and spread over
relatively long durations, it is difficult to produce reliable cost estimates. The
uncertainty can be reduced by concentrating on less speculative projects, but even then
the likelihood of error is high.
Finance
- The returns from investment in research and development and innovation are uncertain and difficult to estimate. The managers initiating the research probably have
more information as to the likely success of the project than the financier. Therefore it
may be difficult to raise finance externally, and the firm may need to rely mainly on
internally generated funds. Consequently research is often underfunded
Employee or trade union resistance
- Organized labour might attempt to resist the adoption of a new technology, if they
view it as a threat to their employment. For example, in the 1970s print unions in the
UK were reluctant to accept technology which allowed journalists to electronically
transfer their copy direct to the photosetting department, bypassing the composing
rooms. Also look into Belfast shipyards.
Regulation
- If an industry is subject to a cumbersome regulatory framework, which perhaps
requires standards for materials, design and safety, the adoption of a new technology
may be sluggish, because amending the regulations may be a slow and bureaucratic
process. For example, Oster and Quigley (1977) find local building codes significantly
reduced the diffusion of new technology in the construction industry.
Patents
- In a free market, new knowledge is a free resource, available to all firms. A possible
consequence is that there may be too little, or no research and development, as the
firms undertaking the investment would be reluctant to see free-riders reap the benefits
of the knowledge acquired from costly and risky research and development investment
(Gallini, 2002). Accordingly, governments offer patents to protect innovators from
over-rapid diffusion.
-

The Schumpeterian hypothesis is often interpreted in terms of an association between

market structure and the pace of technological change. However, this hypothesis is
also consistent with the idea that only large firms have the resources to implement the
large-scale research and development programmes that are required to generate ideas

for new products and new production processes, and to develop these ideas to the
point that they are capable of being implemented commercially.
The argument that technological change is most likely to be driven by large firms
rather than small firms or independent inventors is based mainly on economies of
scale or scope (in one form or another) in research and development, or in adjacent
functions such as finance.
The empirical evidence for a positive association between firm size and the level of
inventive or innovative activity is not particularly strong, and in some cases it may
even point in the opposite direction. For example, Hamberg (1966) finds only seven
out of 27 major inventions during the period 194755 emanated from company
research and development departments. In a more extensive study covering 61 major
inventions during the period 190056, Jewkes et al. (1969) find that the majority
emanated from small private inventors, rather than from the research departments of
large firms.

4. What factors should be considered by policy makers when deciding the duration of patents? Is
it possible that patents might slow the pace of technological change?
-

Patents give incentive to invent by creating opportunity for inventor to earn monopoly
rent.
- Implies socially sub-optimal utilisation of innovation.
Optimal patent period is shorter:
- The higher the price elasticity of demand for the product;
- The greater the benefit yielded by a given unit of R&D expenditure.
The key is to find a balance between the innovators ability to earn a return on its
R&D investment and the benefits that will accrue to consumers once the patent
expires and competition merges.
A rational patent office will realise that its choice of the time a patent is in effect, will
also affect the firms choice of R&D effort. Therefore the best way to do this is for the
patent office to determine the innovators profit maximising research intensity, x*(T),
as a function of T.
To choose the optimal T, the patent office will wish to pick the patent duration that
maximises the net social gain to both consumers and producers given how the firms
choose their research intensities.
Optimal patent duration is finite. As the patent office increases initially the patent
duration it induces greater R&D effort, and at first, a greater discounted net surplus to
producers and consumers. Beyond some point however, continued increases in T will
reduce net social surplus even though they lead to more R&D and therefore greater
reductions in production cost. This is because whilst R&D may be still increasing, an
excessive patent period may stifle other technological advancement in the same area,.
Two forces work to limit the optimal value of T. First is our assumption of diminishing
returns to R&D activity, because it becomes progressively more expensive to lower
production costs, it will take progressively greater increases in T to achieve a given
additional cost saving. The second force limiting optimal patent duration is
discounting. Consumer benefits of an innovation may be not fully realised until a
patent expires.
Yang and Tsou (2002) examine the propensity to patent following a change in the
Taiwanese patenting system in 1994, which increased the duration of patents.

Although the number of patents increased after the change, this may have been mainly
due to factors other than the change in duration.
5. What does empirical evidence suggest about the relationship between firm size and the rate of
technological innovation? Is this evidence supportive of Schumpeters theory of technological
advance?
Symeonidis (1996)
- Over the 1956-1983 period, innovation intensity increased steadily for firms with less
than 500 employees and declined for firms with more than 500 and less than 10000
employees. Hence, small firms were important innovators, and increasingly so. For
example, during the 1960s innovative intensity was highest in the 1000-1999 and
50000+ size classes, while in the late 1970s and early 80s it was highest in the 100199, 200-499 and 50000+ size classes. It should also be noted that, as these numbers
suggest, the very largest firms were consistently the best performers throughout the
1956-1983 period.
- The review shows that there is little evidence in support of the Schumpeterian
hypothesis that market power and large firms stimulate innovations: R&D spending
seems to rise more or less proportionally with firm size after a certain threshold level
has been passed, and there is little evidence of a positive relationship between R&D
intensity and concentration in general.
-

However, positive linkages between concentration/size and innovative activity can

occur when certain conditions are met, including high sunk costs per individual
project, economies of scale and scope in the production of innovation rents. Recent
empirical work suggests that R&D intensity and market structure are jointly
determined by technology, the characteristics of demand, the institutional framework,
strategic interaction and chance.