ECONOMICS OF INNOVATION AND INTELLECTUAL PROPERTY
Simon Kuhn
LECTURE 1. INTRODUCTION
1.1 COURSE OUTLINE
This course on the economics of innovation and intellectual property has 2 goals:
1. Understanding the economics behind innovation
→ what is the economic meaning of innovation?
→ why is innovation important?
→ what drives innovation?
⇒ lectures 1 to 4
2. Understanding innovation policy
→ why do we want government interference?
→ when and how should that interference take place?
⇒ lectures 5 to 10
1.2 INTRODUCTION TO ECONOMICS OF INNOVATION
HISTORY OF INNOVATION
Since the Industrial Revolution (1850), human welfare in terms of GDP per
capita has grown exponentially.
Why is this important?
→ the industrial revolution resulted in the birth of innovation
→ mankind learned how to use the scientific process and to monetize it
Apart from monetary welfare, innovation has also resulted in:
- a higher life expectancy
- better productivity per hour worked
- higher technology adoption
- lower electricity prices
- less time and money to sequence a human genome
- …
A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise
its output per worker ( = productivity).
Why? → most countries do not have extensive mineral wealth or oil reserves. Hence they cannot get
rich by simply exporting them. The only way for societies to become more wealthy is through providing
more output for the same number of inputs.
How is this important? → innovation is the only way this productivity growth happens.
That is the reason why we see so many new inventions and thus budgets spent on Research and
Development. In this course, however, we will research whether or not enough is spent on R&D.
THE CASE FOR INNOVATION POLICY
We can agree that innovation is good for society (after all, it makes a community more wealthy).
Innovation is also good for businesses: they can use it to stay ahead of competition and increase profits.
1. But: firms invest less in R&D than is socially optimal.
→ society will always benefit more from innovation than all the firms that spent money on R&D together
→ innovation is also hard to finance, especially for promising startups
⇒ therefore we need government interference (innovation policies)
2. We notice that productivity growth is slowing, even though firms are investing more and more in R&D
→ maybe it has become harder to find new ideas
→ this also disincentivizes companies from further spending on R&D though important
⇒ therefore we need government interference (innovation policies)
,1.3 HOW DO ECONOMISTS THINK ABOUT INNOVATION
KNOWLEDGE, TECHNOLOGY, INVENTION, INNOVATION, AND DIFFUSION
How do we get to “an innovation”? In theory, there is a linear evolution but in practice, steps may be
skipped or might take longer to fulfill.
1. Knowledge
a. Codified knowledge
→ knowledge that can be transferred by writing it down
→ e.g. chemical formulas, computer algorithms
b. Tacit knowledge
→ knowledge that is embodied in individuals and cannot be easily transferred
→ skills that need practice in order to adopt them
→ e.g. drawing, laboratory skills
2. Technology
= the production techniques used to design, make, package, and deliver goods and services
→ application of selected parts of knowledge to produce economic value
→ the available technology determines a firm’s productivity
3. Invention
= an idea resulting from chance or from systematic research
→ inventions are knowledge
→ not every invention is innovation though
4. Innovation
= turning an invention into an economically useful good
→ an innovation is hence a technology that solves a problem / addresses a demand
5. Diffusion
= process through which innovations become used by others
→ yields societal welfare: through diffusion, society can benefit from an innovative technology
TYPES OF R&D
Research and Development is often a proxy for innovation, but inventions (and innovation) can also
originate without R&D: think about marketing techniques etc.
Research and Development has 3 substages:
1. Basic Research
= to gain understanding without a specific application in mind
→ essential, but less profitable for firms
→ there are no immediate and monetizable applications
→ so primarily conducted by the public sector (government, universities,...)
→ e.g. developed a new rubber compound
2. Applied Research
= to solve a problem
→ e.g. testing performance of the new rubber compound on car tires
3. Development
= to use gained knowledge in new products and processes
→ using the new compound for the development of better tires
We can conclude that firms tend to underinvest in R&D, but specifically in Basic Research.
,WAYS TO INNOVATE
There are different ways to end up at an innovation:
1. Product innovation
= a new or significantly improved product or service
→ e.g. the first MP3 player (market novelty) or the iPod (improvement)
2. Process innovation
= a cost reduction or increase in quality in production
→ e.g. a new method of casting aluminum
3. Marketing innovation
= a new marketing method in design, packaging, placement, promotion or pricing
→ e.g. ecommerce
4. Organizational innovation
= new business practices for organizing procedures
→ e.g. ERP systems
Often, an innovation is a combination of several. We can call this a business model innovation.
THE INNOVATION PROCESS
We can combine the above elements into a general diagram of
the innovation process. This is in theory how innovation
establishes itself in society, but this is not necessarily what
happens in practice.
Diffusion is as important as the rest, as technology needs to be
used in order to be useful.
→ it can take a while though: adoption of telephones took almost
80 years!
WHO INVESTS IN INNOVATION?
There are 2 obvious players in the innovation space:
1. the private sector
→ intangible assets have become a competitive advantage
→ R&D is important
2. the public sector
→ provides incentives (e.g. subsidies, tax treatments, patents), builds infrastructure (e.g.
universities, research centers) and compensates in areas where firms underinvest through policy
1.4 MICROECONOMICS OF INNOVATION
ASSUMPTIONS
We assume that:
- goods are homogeneous and firms compete on price
- perfectly competitive market → an infinite amount of identical firms compete
- process innovation
a. reduction in marginal cost of production
b. drastic or non-drastic
- there is a first-mover advantage for one firm
,DRASTIC PROCESS INNOVATION IN A COMPETITIVE MARKET
Before innovation:
→ all firms produce a homogenous good at 𝑚𝑐 = 𝑐0 = 𝑃
→ the output per firm is 𝑞𝑐0
→ because we are in a competitive market, profits per firm are 0
After innovation by one firm:
→ the firm can set its marginal cost at 𝑐𝑑
𝑚
→ it become a monopolist and produces 𝑞𝑚 charging 𝑝 which is lower than 𝑐0
→ because he is now a monopolist, the innovator is the only one in the market
𝑚
and he is able to generate a profit of π𝑚 = 𝑞𝑚 × (𝑝 − 𝑐𝑑)
The expenditures the innovator is willing to make are obviously dependend on the
amount of profit the firm is able to reap after innovating.
NON-DRASTIC PROCESS INNOVATION IN A COMPETITIVE MARKET
Before innovation:
analogue to the situation above
After innovation of one firm:
→ the firm can set its marginal cost at 𝑐𝑛𝑑
→ if it were to become a monopolist, it could try to set its price to
𝑚
𝑝 however this price is greater than 𝑐0 (= price on the market)
→ this way, the innovator is not able to drive the others out of the market
𝑚
→ and since any price other than 𝑝 would not be optimal:
it has no incentive to become a monopolist
→ the firm can now keep selling at 𝑐0 but will still make a profit of
π𝑖𝑛𝑛𝑜𝑣𝑎𝑡𝑜𝑟 = 𝑞𝑐0 × (𝑐0 − 𝑐𝑛𝑑)
So if a firm understands that its process innovation will not be drastic, it must
assess whether the profit that still can be attained is great enough.
INCENTIVES TO INNOVATE
Cost-reducing process innovations can create monopolies when the cost reductions are drastic enough.
→ we can generalize this for product innovation: each product represents a technology that can now
replace an older technology that was used in our processes, hence also pulling down the MC.
Because of this, firms have an incentive to invest in creating these innovations.
But, we still see an underinvestment. Why? → following lectures.
1.5 MARKET STRUCTURE AND INNOVATION
HISTORY
Joseph Schumpeter was one of the first economists to think about market structure and innovation.
He had multiple ideas that also evolved:
1. Schumpeter — Mark I: innovation happens because dominant firms are outcompeted by startups
that have better ideas. It is about the individual.
2. Schumpeter — Mark II: innovation happens because dominant firms have a lot of resources to
develop new inventions, and short-term monopolies guarantee returns. It is about large firms
with lots of market power.
,Both happen:
1. Netflix vs. Blockbuster → Mark I: it is about the “individual” company with the newest idea.
2. Microsoft buying Blizzard → Mark II: it is about large firms who have the power to buy innovation.
ADVANTAGES FOR LARGE FIRMS IN INNOVATION
1. Externalities: large firms with many products can better exploit an unexpected discovery
2. Indivisibilities: large firms have more resources and can exploit economies of scale and scope
3. Uncertainty: innovation is inherently risky and large firms can better cope with risk
This can be empirically established:
- the probability that a firm does R&D increases with size
- but the number of innovations per unit of R&D spending decreases with firm size
- but then again, large firms have a lower average cost of R&D
This, however, does not indicate that small firms cannot innovate. We will see later on in lecture 4 that
smaller firms (with less Internal Funding) will need to get subsidized by the government.
ARROW MODEL
Using the Arrow Model, we are able to compare the most extreme market structures to find out if
innovation incentives depend on market structure.
Assumptions:
a. homogeneous products
b. 𝑝 = 100 − 𝑄
c. 𝑚𝑐 = 𝑐0 = 50
d. non-drastic innovation, no uncertainty
e. innovation leads to a decrease of 𝑚𝑐 to 𝑐1 = 25 < 𝑐0
MONOPOLIST
Before the innovation:
→ the monopolist sets a price at 𝑝0 = 75
→ his profit is equal to π0 = 𝑞0 × (𝑝0 − 𝑐0) = 25 × (75 − 50) = 625
After the innovation:
→ the monopolists sets a price at 𝑝1 = 62. 5
→ his profit is equal to π1 = 37. 5 × (62. 5 − 25) = 1, 406. 25
Hence, the profit incentive for the innovation is
1, 406. 25 − 625 = 781. 25
PERFECT COMPETITION
Before the innovation:
→ the profit of each firm is π0 = 0 since we are in perfect competition
After the innovation:
→ the firm can sell its original amount of 𝑞0 at a price a little lower than 𝑐0
to achieve the greatest amount of profit: 𝑝1 = 50 − ε
For this model, we set ε to be infinitely small and thus negligible.
→ profit becomes π1 = 𝑞0 × (𝑝1 − 𝑐1) = (100 − 𝑝1) × (𝑝1 − 𝑐1)
for which we know Q through the demand function given
⇔ π1 = (100 − 50) × (50 − 25) = 1, 250
Hence, the profit incentive for the innovation is
1, 250 − 0 = 1, 250
, Under the same parameters, we can see that the profit incentive is higher in a perfectly competitive
industry than in a monopoly → Schumpter, Mark 1
→ monopolists already make profit, competitive firms do not
→ and there is replacement effect: sometimes firms simply replace their own profits when they innovate
SOCIAL PLANNER
The social value of innovation is still higher than for the monopolist or for
the competitive firm.
→ this is almost always the case
Why?
Competitive firms fail to appropriate the increase in consumer surplus.
→ for society: we should always innovate
Monopolist: 1
Competitive firm: 1 + 2
Social value: 1 + 2 + 3
PRODUCT INNOVATION
Is much more complicated and there are less clear predictions.
→ we need to take into account product differentiation and price discrimination
→ there is less replacement effect if older products are not cannibalized
a. Non-drastic innovation: competitive firm may still face a lower replacement effect than a
monopolist and therefore have larger incentives to innovate
→ On the other hand, the monopolist may be able to sell more units (and price discriminate)
and therefore have larger incentives to innovate
b. Drastic innovation (new product makes old product obsolete): The competitor may have
greater incentives to innovate if competition in the old product is intense
LECTURE 2. MARKET STRUCTURE AND INNOVATION
2.1 RECAP
In the last lecture, we discussed the Arrow Model with which we were able to calculate the incentives to
innovate for both monopolists as firms in perfect competition.
We discovered that a firm in perfect competition always has a larger incentive to innovate
→ replacement effect: as the monopolist is the only firm in the market, it is less incentivized because
innovation would simply cannibalize its current market.
What if we also add strategic interaction?
→ i.e. innovation could change the market structure: how would firms then react?
2.2 INNOVATION IN OLIGOPOLIES
INCENTIVES TO INNOVATE IN OLIGOPOLIES
Oligopolies are intermediate market structures where n firms compete
→ are the incentives between those in perfect competition and those in a monopoly? NO
The incentives to innovate are affected by the intensity of competition:
- the number of firms
- the degree of product differentiation or substitutability
- the type of competition (price: Bertrand vs. quantity: Cournot)
