1. technology and computing
2. technological innovation

Management of New Technology
Ec261
Lecture 7
1
Introduction
We will start with a historical review of the economic theory of the links
between market structure or firm size and innovation and look at
some empirical results.
We will see from these results that there is no conclusive empirical link
between market structure or firm size and innovation.
We will then examine recent theory and we will see that there are,
indeed, forces that tend to favour innovation in highly competitive
markets as well as forces that tend to favour innovation in highly
monopolised markets (or, at least, innovation by incumbents rather than
new entrants).
We will conclude with a discussion of theory and evidence pointing to
an “inverted U” relationship between market structure and innovation,
with moderately competitive markets generating the highest innovation
rates.
2
Week 7 Outline
 Historical review of theory and evidence
 Market structure and the incentive to innovate
 Incumbents, entrants and the incentive to innovate
 Firm size, market structure and innovation: economic
mechanisms
 Competition and innovation: an inverted-U relationship
3
Innovation and Market Structure
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?
1. Firms require an expectation of some (perhaps transient) market
power to have the incentive to invest in R&D.
2. In an oligopolistic market, behaviour by rivals is more predictable and
this reduces the uncertainty associated with innovative effort.
3. Large firms might not be as financially constrained as small firms.
4
Innovation and Market Structure
This view of large firms and concentrated markets as engines of
innovation and growth sets static efficiency losses against dynamic
efficiency gains.
 Some static resource misallocation costs estimates are very small
(less than 1% of GNP – Harberger 1954), others are substantial
(4-13% of 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
in lecture 1 on the contribution of technology to growth.
In other words, the dynamic efficiency gains might justify static
efficiency losses.
5
Innovation and Market Structure
Schumpeter’s view sparked a literature that tests two hypotheses:
 Innovation increases more than proportionately with firm size
 Innovation increases with market concentration
Overall, both the empirical and theoretical literature on these two
hypotheses have been inconclusive.
6
Innovation and Market Structure
Scherer (1967) finds an “inverted U” relationship between concentration
and R&D intensity with a “four-firm concentration ratio” of 50-55% being
“best”.
When the effect of technology class is compared to the effect of market
structure, however, technology class appears a far more important
determinant of innovativeness than market structure.
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.
7
Innovation, Firm Size and Market Structure
See Symeonidis, OECD Economic Studies, 1997
Symeonidis (1997) surveys the empirical literature. Main findings:
1. Very small firms do little R&D and produce a less than
proportionate number of innovations.
2. Above a certain threshold firm size, R&D seems to rise more or
less proportionally, on the whole, with firm size, although there
are variations of this pattern across industries, time periods and
countries.
3. The evidence on the relationship between innovative output and
firm size is inconclusive; most authors find that innovative output
tends to rise less than proportionately with firm size, although
other patterns have also been suggested for particular industries,
periods or countries.
8
Innovation, Firm Size and Market Structure
Symeonidis (1997) survey (cont.):
4. There is little evidence of a positive relationship between R&D
intensity and market concentration in general, although there may
be circumstances where such a relationship exists.
5. There is even less evidence of a positive impact of concentration
on innovative output.
6. Industry characteristics such as technological opportunity explain
much more of the variance across firms and industries in R&D
intensity or innovation than market structure or firm size.
9
Innovation, Firm Size and Market Structure
Limitations of studies that examine the effect of firm size or market
structure on innovation:
• Problems with measuring innovative activity: none of the
measures (R&D expenditure, patent counts, number of significant
innovations) is entirely satisfactory.
• Firm size and market structure are likely to be “endogenous”.
• Difficult to fully control for industry-specific characteristics which
affect innovation and may be correlated with concentration or firm
size.
10
Market Structure and Incentives to Innovate
Let’s go back to theory and see where the ambiguity may be
coming from…
What market structures are most conducive to innovation?
A good way to identify some important mechanisms is to ask:
How do a monopolist’s incentives to innovate compare
to the incentives of a perfectly competitive firm?
We will first consider a firm’s incentive to carry out R&D in order to
reduce its cost when the alternative to this firm’s innovation is no
innovation by any firm.
We assume:
homogeneous good
constant marginal (and average) cost.
11
Price
PM
PM’
PC=P’
Monopolist net gain:
+
–
P.C. firm net gain:
+
– 0
MC
MC’
Incremental
Demand
0
Quantity
MR
Price
Monopolist net gain:
P.C. firm net gain:
PM
PC
–
– 0
MC
PM’
Drastic
Demand
0
MR
MC’
Quantity
12
Market Structure and Incentives to Innovate
In the case of drastic innovation, the monopolist’s gain from
innovation is clearly less than that of the p.c. firm.
In the case of incremental innovation, it is slightly less clear from
the graph, but it can be shown that the gain of the p.c. firm again
exceeds that of the monopolist.
Note: the graphs portray the p.c. firm undercutting its rivals and
capturing the entire market – but the price it can set depends on
the nature of the innovation (drastic or incremental).
13
Market Structure and Incentives to Innovate
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 of “old profits”.
The p.c. firm, on the other hand, was earning zero profits with
the old process, hence there is nothing to “replace”.
For both the monopolist and the p.c. firm, there
is a gain due to the lower marginal cost (efficiency gain).
For the p.c. firm, 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 a weaker incentive to innovate.
14
Market Structure and Incentives to Innovate
Recall that Cohen and Levinthal (lecture 3) observed higher
innovation rates associated with higher levels of competition.
Policy issue: Should we reduce concentration in the product
market in order to increase 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 than in other markets.
Management issue: (Going beyond the model just presented, as we
now have in mind an asymmetric leader-follower oligopoly, but
based on the same intuition)
The current leader in an industry would normally expect not to
maintain its position … and this may be (privately) optimal.
15
Incumbent, Entrant and Incentives to Innovate
We have been comparing the incentives to innovate of a
monopolist to those of a perfectly competitive firm…
But we could have also defined these firms as an incumbent and
a potential entrant.
An incumbent suffers the replacement effect from an innovation,
while an entrant does not.
Our model so far suggests that when the alternative to a firm’s
innovation is no innovation by any firm, the potential entrant has
a stronger incentive to innovate than the incumbent.
Note: we have analysed the case of process innovation. For a
product innovation, the results are more ambiguous.
16
Incumbent, Entrant and Incentives to Innovate
But there is also an alternative argument which goes
the opposite way…
We have assumed that there is no competition in the market
for innovation: innovations “fall into the lap” of a single firm.
Consider now the incentives of a single firm to invest in
innovation when the alternative to innovation by that firm is that
another firm innovates. Assume also that innovation is
incremental.
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 obtain the rights to an innovation?
17
Incumbent, Entrant and Incentives to Innovate
Consider the following model. We have:
• two firms, an incumbent and a potential entrant
• an R&D lab that wishes to sell an innovation to the firm that
is willing to pay the most
• the innovation lowers marginal and average cost from ch to cl
• homogeneous product.
If the incumbent firm obtains the new technology, it will make
monopoly profit.
If the potential entrant obtains the technology, it enters the market,
which therefore becomes a duopoly. Each firm gets duopoly profit.
How much will a firm bid?
A firm will be prepared to bid up to the difference in its profit
between getting the innovation and not getting it.
Note that the “old profit” is no longer relevant here.
18
Incumbent, Entrant and Incentives to Innovate
Outsider (entrant) bid: Πd(cl,ch) – 0, where the first term reads
“duopoly profit with own cost cl and competitor’s cost ch”.
Insider (incumbent) bid: ΠM(cl) – Πd(ch,cl), where the first term
reads “monopoly profit with own cost cl” and the second term
reads “duopoly profit with own cost ch and competitor’s cost cl”.
Which of these “bids” is larger? Note that:
ΠM(cl) – Πd(ch,cl) > Πd(cl,ch) – 0  ΠM(cl) > Πd(cl,ch) + Πd(ch,cl)
So the question becomes: Is monopoly profit by a low-cost firm
greater or less than total profit of a duopoly when one duopolist is
low-cost and the other high-cost?
In most models, the monopoly profit is greater.
So the insider (incumbent) outbids the outsider (entrant).
19
Incumbent, Entrant and Incentives to Innovate
Conclusion: When the alternative to innovation by one firm is that
another firm innovates and innovations are incremental, the
incumbent/monopolist firm has a greater incentive to obtain new
innovations in order to preserve a favourable industry structure.
The incumbent has more to gain from obtaining the new technology
than the potential entrant. As a result, the incumbent’s dominance
over the industry will tend to persist over time.
Implication: Reducing barriers to entry into the research/innovation
market will preserve the incentive to innovate for incumbent firms.
20
Incumbent, Entrant and Incentives to Innovate
In fact, the incumbent’s incentive to innovate may be so strong
that it results in socially excessive innovation…
Suppose the innovation does not lower cost (i.e. cl = ch), it only
allows another method of obtaining the same cost level, hence
allowing entry. Which firm has a greater incentive to obtain a
patent and hold this innovation, an incumbent or an entrant?
ΠM(ch) – Πd(ch,ch) > Πd(ch,ch) – 0  ΠM(ch) > Πd(ch,ch) + Πd(ch,ch)
In most models the above inequality holds, so the incumbent still
has the greater incentive to obtain the innovation, even if it will not
be used (since it does not lower cost at all). The innovation is
socially wasteful.
21
Persistence of Leadership vs. Leapfrogging
According to our theory so far, we should observe “persistence of
monopoly” rather than “leapfrogging” when there is competition in
the innovation market (i.e. when the alternative to innovation by
one firm is innovation by another firm).
But the evidence suggests that we observe persistence sometimes
or in some industries and leapfrogging at other times/industries.
Why? Maybe our model so far has not captured some essential
aspect of competition in some real-world times/industries?
Let’s try using a slightly different model: two firms, initially with the
same marginal cost. An innovation comes up which can allow only
one of them to reduce its marginal cost.
Then a second innovation comes up which again can be used by
only one firm and leads to an even greater reduction in mc.
What will happen?
22
Persistence of Leadership in Bertrand Markets
Assume:
• homogeneous product
• firms have constant marginal and average costs
• Bertrand competition
Main characteristics of Bertrand competition:
• Price competition (with no capacity constraints)
• Aggressive pricing resulting from ease with which a firm can
steal customers away from competitors  tough competition
• With at least two firms, outcome is perfectly competitive:
prices fall to marginal cost and profits are zero, at least
when all firms have the same marginal cost
• If one firm has a higher marginal cost, the low-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.
23
Price
ch
cl
Demand
Quantity
0
Q
High-cost firm cannot price below ch.
Low-cost firm can price at or slightly
below ch and serve the entire market demand,
selling Q units and obtaining profit of
24
Persistence of Leadership in Bertrand Markets
In our model there are three cost levels: ch > cm > cl.
Two firms, they both start at ch.
There are two periods.
Each firm bids in each period to be the exclusive owner of a
technology that lowers its cost.
Hence, the period 1 winner will have cm, while the competitor
retains ch. The period 2 winner will have cost cl.
How much will a firm bid? A firm will be prepared to bid up
to the difference in its profit between getting and not getting
the technology in a given period.
25
Persistence of Leadership in Bertrand Markets
Let A and B bid in period 1. Both will bid Πd(cm,ch) – 0.
Let’s say we arbitrarily choose A to be the winner.
At the end of period 1, 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 firm with the higher bid wins in period 2.
Will it be firm A again or will it now be firm B?
In other words, does a single firm have the incentive to
develop all innovations or will the firms exchange “winner”
role?
26
Price
ch
cm
cl
Bids in period 2
Demand
0
Quantity
Q Q’
The winner in period 2 has cost cl.
The price the winner will set will be equal to the cost level
of the loser.
Πd(cl,ch) =
+
Πd(cl,cm) =
+
A’s bid is higher: the winner in period 1 has a greater incentive to win
in period 2 as well. This leads to “persistence”.
27
Leapfrogging or Persistence in Cournot Markets
Assume:
• homogeneous good
• constant marginal and average costs, ch > cm > cl (as before)
• Cournot competition
Main characteristics of Cournot competition:
• Quantity competition or competition in capacities with price
adjusting to clear the market, or price competition with capacity
constraints
• Firms produce to capacity and market share is hard to steal,
so there is unaggressive response to rival changes in capacity
• In fact, the larger your quantity (capacity), the smaller my
quantity (capacity) – otherwise equilibrium price will be too low
and my profit will suffer
• Positive profits for all industry participants.
28
Leapfrogging or Persistence in Cournot Markets
Period 1 bids
As before, each firm bids up to the difference between winning and
losing: Πd(cm,ch) – Πd(ch,cm).
As before, we suppose that firm A wins.
Period 2 bids
Now A has lower cost than B. A bids up to the difference between
what it gets if it wins and what it gets if it loses: Πd(cl,ch) – Πd(cm,cl).
Similarly, B bids up to: Πd(cl,cm) – Πd(ch,cl).
Which one is bigger?
In fact, we can have either result. It depends on the specific demand
and costs assumed.
So we can have either “persistence” or “leapfrogging”…
29
Persistence of Leadership vs. Leapfrogging
In some industries (e.g. pharmaceuticals) we tend to see increasing
dominance in some classes of drugs but leapfrogging in other classes,
so even at the industry level it is hard to generalise.
What can we say about patterns of innovation, then?
For one thing, we would expect that the pattern of change in leadership
would reflect the dominant oligopoly model for the industry: price or
quantity (capacity) competition.
But do firms compete by setting quantities? Maybe in some markets…
There is, however, also a more general and useful interpretation of
quantity competition: competition between firms with capacity
constraints.
30
Persistence of Leadership vs. Leapfrogging
Capacity-constrained firms have no incentive to reduce price a lot since
they cannot produce a lot of extra output  their response to rival
action is unaggressive and competition is not very tough.
In fact, Cournot outcomes can emerge from a two-stage process where
firms first choose their capacities and then, given these capacities, they
choose prices.
Hence, the Cournot model is appropriate for industries where firms are
capacity-constrained, the Bertrand model for industries where they are
not.
Even in the same industry, Cournot-type behaviour may be more
common in economic upturns (as capacity constraints become binding)
whereas Bertrand-like behaviour may be observed more in downturns.
Hence, the pattern of leadership we observe may vary over the
economic cycle – if innovation decisions occur in a short enough
interval to adjust to the business cycle.
31
Competition and Innovation:
An Inverted U Relationship
See Aghion, Bloom, Blundell, Griffith, Howitt (2005)
Assume:
• Process innovation (lowering marginal cost)
• Innovation is step-by-step (a firm must get even before it can get ahead)
• Imitation is such that a firm can be at most one step behind
• Profitability depends on lead (so if one step ahead, a firm earns more
than if tied with the other firm)
 As soon as you are a leader (i.e. one step ahead) there is not much
benefit to innovating because you can never pull more than one step
ahead. So in asymmetric industries, only the follower has an incentive
to innovate and catch up with the leader.
 If you are tied (“neck-and-neck”), there is an incentive for both firms
to pull ahead, since there is a big benefit to leading and it takes only
one step ahead to become a leader.
32
Competition and Innovation
However, innovation incentives also depend on the degree of competition.
 Higher product market competition (or lower market concentration)
in neck-and-neck industries implies lower profits,
hence a lower payoff to not innovating,
hence HIGHER innovation incentives: “escape competition” effect.
 Higher product market competition in asymmetric industries
means lower profits to followers who catch up with the leader,
so LOWER innovation incentives: a Schumpeterian effect.
 Whether higher product market competition leads to more or less
innovation overall 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”.
33
Competition and Innovation
Assume initially high product market competition in a sector.
The neck-and-neck industries tend to become asymmetric
(because their innovation rates are high)…
whereas the asymmetric industries tend to remain asymmetric
(since their innovation rates are low).
Hence, when product market competition is initially high, most
industries will be asymmetric.
Since most industries are asymmetric, a decrease in competition
will raise the innovation rate (the Schumpeterian effect
dominates).
34
Competition and Innovation
Now assume initially low product market competition in a sector.
Neck-and-neck industries remain neck-and-neck
(since there is little incentive to innovate),
whereas the asymmetric industries tend to become neck-and-neck
(as their innovation rate is high).
Hence, when product market competition is initially low, most
industries will be neck-and-neck.
Since most industries are neck-and-neck, an increase in
competition will raise the innovation rate (the “escape
competition” effect dominates).
35
Competition and Innovation
The bottom line:
Starting from high product market competition (PCM), a decrease
in PCM raises the innovation rate.
Starting from low product market competition, an increase in PCM
raises the innovation rate.
We therefore get an “inverted U” relationship between
competition and innovation: intermediate levels of competition are
associated with highest innovation rates.
36
Competition and Innovation
high
Innovation
rate
low
low
Product market competition
high
The “inverted U” relation is the result of the “Schumpeterian”
and “escape competition” effects combined with the “composition”
effect.
The authors test this on UK industry-year data, using
citation-weighted patents as their measure of innovativeness and
price-cost margins as their measure of product market competition.
They find support for an inverted U relationship.
37
Innovation, Firm Size and Market Structure:
Evidence on Specific Mechanisms
See Symeonidis, OECD Economic Studies, 1997
Much of the theory we have reviewed basically asks the question:
“Which type of firm benefits more from developing an innovation?”
However, this is not the only important question to ask.
Let’s go back to some of the specific factors that bear on the links
between innovation, firm size and market structure.
These factors include:
• sunk cost of R&D
• diversification
• appropriability conditions
• financial constraints
We briefly look at the empirical evidence on each of these.
38
Innovation, Firm Size and Market Structure
Claim 1: R&D projects typically involve large sunk costs, and these
can only be covered if sales are large – therefore large firms have
an advantage over small firms.
Evidence: Some but not all R&D involves large sunk costs.
Claim 2: Large firms but not small firms can undertake many projects
at any one time and hence spread the risks of R&D or can benefit
from economies of scope in the production of innovations.
The evidence on whether diversification favours innovative activity is
inconclusive.
39
Innovation, Firm Size and Market Structure
Claim 3: Firms with greater market power can more easily
appropriate the returns from innovation and so they have better
incentives to innovate.
The evidence on whether firms with greater market power benefit
more easily from patents or strategic IP protection is mixed.
Claim 4: Large firms have generally better access to external
finance. Moreover, firms with greater market power are better
able to finance R&D from own profits.
Evidence: Yes, on the whole.
40
Endogeneity of Innovation and Market Structure
Recent research suggests that market structure and R&D intensity
are jointly determined by technology, demand characteristics, the
institutional framework, strategic interaction and chance:
 Certain characteristics of technology – such as the degree of
continuity and predictability of technology and the extent of learning
economies in innovation – are important determinants of the evolution
of technological leadership and the degree of turbulence in R&Dintensive industries.
 Demand characteristics such as the degree of product differentiation
affect the extent to which high R&D intensity will be associated with a
high level of market concentration.
 Technological events and random differences between firms in
innovation and growth play an important role in shaping the evolution
of market structure and innovative activity in R&D-intensive industries.
41
Summary
 The proposition that innovation is linked to firm size and industry
concentration has generated a large theoretical and empirical
literature because of its antitrust implications.
 Theory and empirical evidence are mostly inconclusive, with
some research suggesting that intermediate levels of competition
generate the most innovation.
 Other work supports opening up markets as a means of spurring
innovation.
 Some studies question the magnitude of the product market
competition effect on innovation relative to other factors.
 Other studies emphasise how various industry characteristics
jointly influence innovation and market structure.
42
Read the case study “The race to develop
human insulin” on ORB before next lecture.
43