Industrial Organization. R&D and Innovation

Transcription

1 In the Name of God Sharif University of Technology Graduate School of Management and Economics Industrial Organization ( st term) Dr. S. Farshad Fatemi R&D and Innovation

2 What explains the variation in R&D spending and innovative activity across industries? How does industry structure affect the rate of innovation? And how does innovation affect industry structure? Do the same firms persist as market leaders, or does leapfrogging occur? Does the market generate the socially optimal amount of investment in R&D? Should firms be allowed to cooperate in R&D activities? Industrial Organization Dr. F. Fatemi Page 204

3 Features of R&D process Large, up-front sunk costs Risky Spillovers Cumulative process Importance to technological progress Definitions Process / product innovation Invention / innovation Drastic / non-drastic innovation Diffusion Industrial Organization Dr. F. Fatemi Page 205

4 Knowledge as a public good Public good features of knowledge Non-rivalrous Difficult to exclude Suppose Process innovation: reduces marginal cost to c R&D is costly Free entry Free-rider problem Entry innovating firm must set p = c immediately R&D costs cannot be recovered; R&D will not be undertaken Solutions: barriers to entry & limited spillovers; patents Industrial Organization Dr. F. Fatemi Page 206

5 R&D with fixed market structure Suppose Barriers to entry: market structure is fixed Spilloverswithin industry, but not outside Schumpeterian view: concentration encourages R&D Static vs. dynamic efficiency of competitive markets 2 reasons Monopoly profit is the beacon attracting innovative activity Limited spillovers to other firms in industry Look at R&D incentives under (i) monopoly (ii) duopoly Industrial Organization Dr. F. Fatemi Page 207

6 R&D incentives under monopoly Problem: too little R&D is undertaken (Unless perfect price discrimination) R&D incentives in a duopoly 2 firms in market One firm innovates, other gains by diffusion Too little, and some waste of, R&D effort Industrial Organization Dr. F. Fatemi Page 208

7 R&D with patent protection Now assume that inventor gains patent protection What does a patent do? Grants exclusive right to innovator (first to innovate / file) For a limited period only, followed by full disclosure Assume patent grant confers monopoly power With patent protection, competitive market provides greater incentive to innovate than monopoly, as the innovator gains monopoly power Look at alternative pre-innovation market structures (i) monopoly (ii) perfect competition Industrial Organization Dr. F. Fatemi Page 209

8 Patent grant to a monopoly No change in market structure As before R&D incentive too low as CS not appropriated Too little R&D is undertaken Replacement effect : monopolist replaces itself Industrial Organization Dr. F. Fatemi Page 210

9 Patent grant under perfect competition Innovation changes industry structure Perfect competition monopoly 2 cases Drastic innovation New monopoly price undercuts old cost level (and competitive price) Non-drastic innovation New monopoly price does not undercut old cost level (competitiveprice) Industrial Organization Dr. F. Fatemi Page 211

10 Conclusions on market structure and R&D Non-appropriability of CS too little investment in R&D Perfect PD would give correct incentives Firm in competitive market has greater incentive than monopolist, as gains it monopoly power Compare pre-and post-innovation profits Duplication of R&D efforts: may be wasteful if 2+ firms engage in R&D Oligopoly: business-stealing ==> R&D may be excessive Industrial Organization Dr. F. Fatemi Page 212

11 Aghion et al.: Competition and Innovation: an Inverted-U Relationship; QJE (2005) Predict, and find, an inverted-u relationship between product market competition (PMC) and innovation At low PMC, escape-competition effect dominates Greater competition reduces pre-innovation rents (more than post-innovation), raising incremental benefit from innovation At higher PMC, Schumpeterian effect dominates Greater competition reduces reward to laggard from catching up with leader, reducing innovation Industrial Organization Dr. F. Fatemi Page 213

12 If firms are neck-and-neck, inverted-u is steeper Escape-competition effect is stronger Degree of neck-and-neckness decreases with higher PMC Composition effect: as PCM increases, relatively greater innovation incentives in neck-and-neck industries tends to unbalance these industries, reducing the fraction of neckand-neck industries in the economy Industrial Organization Dr. F. Fatemi Page 214

13 Endogeneity of industry structure and R&D (Dasgupta and Stiglitz; ; Industrial Structure and the Nature of Innovative Activity; Econ. J.; 1980) They look at determinants of Industry structure (concentration) R&D expenditure Profit margins Find that both are related to underlying model parameters Technological opportunities: responsiveness of costs to R&D Demand elasticity Thus correlations between these factors should not be interpreted as causal relationships Industrial Organization Dr. F. Fatemi Page 215

14 Model Demand is iso-elastic: p = σq -ε ε > 0 is the elasticity of demand Costs: c = βx-α where x = R&D expenditure α > 0 is elasticity of cost to R&D technological opportunities Look at the outcomes under Social planner: first-best Monopoly Free-entry oligopoly Industrial Organization Dr. F. Fatemi Page 216

15 Social Planner Objective: max W = U(Q) c(x)q x Optimality conditions (1) n* = 1 (2) FOC w.r.t. Q: p = U = c Determines Q* (3) FOC w.r.t. x: c Q 1 = 0 Determines x* Outcomes Single firm Price = c; competitive output Q* Optimal investment in R&D to reduce marginal cost c, x* Industrial Organization Dr. F. Fatemi Page 217

16 Monopoly Objective: max Π= p(q)q c(x)q x Optimality conditions (2 ) FOC w.r.t. Q: c = MR = p(1 ε) Q< Q* (3) FOC w.r.t. x: c Q 1 = 0 Same condition as before But Q is lower, so c is larger, i.e. x < x* Outcomes Single firm (as in first-best) R&D investment is too low Monopolist produces too little output, for 2 reasons; Monopoly power (Q < Q* for given cost c) Monopolist under-invests in R&D, as smaller Q over which to spread x; c is not low enough, reducing Q further Industrial Organization Dr. F. Fatemi Page 218

17 Oligopoly Assume Identical firms, homogeneous good: Q =nq Free entry: π= 0 Cournot oligopoly game Firm s objective: max π= {p(q) c(x)} q x FOC in q: p c +qp = 0 FOC in x: qc 1 = 0 Free entry Zero profit condition: π= {p(q) c(x)} q x = 0 Industrial Organization Dr. F. Fatemi Page 219

18 Results Basic parameters are technological opportunities αand demand elasticity ε The following are jointly endogenous Price-cost margin, (p-c)/p R&D-to-sales ratio, nx/pq Industry concentration, n High α low concentration, high PCM, and high R&D-to-sales ratio Correlations between these factors should not be interpreted as causal Industrial Organization Dr. F. Fatemi Page 220

19 Welfare analysis First-best n* = 1 is impractical Second-best What is n* given FOC s? Results n is too high Instance ofmankiw-whinstonexcess entry result x (per firm) is too low Ambiguous whether industry R&D nx is too large or too small Industrial Organization Dr. F. Fatemi Page 221

20 Dynamics of R&D competition Question: Persistence of monopoly Who will win: incumbent or entrant? 2 countervailing effects Efficiency effect (Schumpeterian hypothesis) If incumbent wins, it retains monopoly position If entrant wins, industry becomes duopoly Monopoly π> duopoly π incumbent has greater incentive Replacement effect (Arrow) Incumbent has pre-innovation profit, entrant does not Incumbent replaces itself entrant has greater incentive Industrial Organization Dr. F. Fatemi Page 222

21 Public policy towards R&D The patent system Optimal patent length Criticisms & alternatives Empirical evidence Cooperation in R&D Industrial Organization Dr. F. Fatemi Page 223

22 Patents Legal characteristics Full exclusivity (broader than copyright) E.g. loser cannot use own discovery (if infringes) 20 year term from date of application May be longer for pharmaceuticals & agrochemicals 2 aims Protect invention Provide incentive to innovate by awarding exclusive right Allocate property right: can trade property and use to raise finance Disclose information Consideration for the protection provided Avoid wasteful duplication Allow use in further research: cumulative nature of R&D Industrial Organization Dr. F. Fatemi Page 224

23 Legal framework No international system Individual national patent systems Must apply for patent from each country Europe: European Patent Convention (EPC) Can apply through European Patent Office, but receive a bundle of national patents Relatively fast, but expensive No Community patent : agreed but never implemented Some harmonisation on validity and infringement criteria: EU conventions adopted into national law (e.g. UK Patents Act 1977) Industrial Organization Dr. F. Fatemi Page 225

24 Requirements for a patent Patentable subject matter Excludes scientific discoveries, maths, surgical techniques, areas covered by copyright Novelty: must be new, and unpublished Examination relative to prior art First-to-file (UK) Non-obviousness: must be sufficiently large improvement Industrial application: must have a practical use Disclosure: complete description must be given Scope of protection sought Wider protection given to more significant inventions Industrial Organization Dr. F. Fatemi Page 226

25 Optimal patent length Trade-off between static and dynamic efficiency Model Competitive product market Non-drastic process innovation, c0 c1 x = R&D expenditure Graph B(x): to firm during patent, to consumers after expiry A(x): additional benefit to consumers after expiry Industrial Organization Dr. F. Fatemi Page 227

26 Gain from patent of length T Gain to firm Social welfare Impact of demand elasticity More elastic demand area A is larger shorter T* as static deadweight loss is more significant T* proportional to 1/ε (like Ramsey rule) Also: optimal patent breadth Industrial Organization Dr. F. Fatemi Page 228

27 Criticisms of patent system Many inventions are not patented Costs Disclosure requirement Monopoly power Invention is underused (Q < Q*) Hold-up in licensing may inhibit cumulative research Winner takes all Runners-up get zero return: increases riskiness of R&D Duplication of R&D efforts: common pool problem Industrial Organization Dr. F. Fatemi Page 229

28 Possible alternatives Govt subsidies: pays part / all of R&D cost x Advantage: disseminate information, avoid monopoly power Problems Cost of public funds Asymmetric information on which projects to fund Across-the-board subsidy does not reduce duplication Poor incentives for efficiency Procurement auction Advantages Avoid monopoly provision and duplication Competition between firms promotes efficiency Avoids duplication (if awarded to single firm/research unit) Problems: public funds; govt unlikely to know value of invention Industrial Organization Dr. F. Fatemi Page 230

29 Cooperation in R&D activities Why is cooperation desirable? Overcome free-rider problem arising from spillovers between firms Avoids duplication Size and risk Combines resources / skills of different firms R&D joint ventures often permitted under competition law Horizontal agreement between firms EU: R&D block exemption from Article 81 US: some protection under National Cooperative Research Act 1984 Industrial Organization Dr. F. Fatemi Page 231

30 Cooperative R&D joint ventures Some restrictions Must be least restriction of competition necessary to achieve the objective Unlikely to permit cooperation further down the supply chain Preferable if set up as a separate entity from both parents E.g. Ford and VW set up JV to design a new people carrier Joint production was permitted But separate marketing: Ford Galaxy, VW Sharan Industrial Organization Dr. F. Fatemi Page 232