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Economics of Innovation

Innovation and market structure: Introduction

Manuel Trajtenberg

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Arrow: Innovation/Knowledge as an economic good

Innovation: creation of new knowledge.

• Knowledge (K) as public good: Non-rival in use, and hard to exclude (but not impossible)

• Intangible, K spreads, easy to copy, to imitate.

• Source of spillovers.

•  Paradox with demand – need to know K to assess its value, but once you know it, won’t want to pay for it…

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Characteristics of Knowledge Creation

• High fixed cost, trivial/low costs of reproduction or transmission (wasn’t always like that…)

• Very high uncertainty (risk aversion may prevent undertaking R&D as much as socially desirable)

• “Moral hazard” problem (cannot contract out “creativity efforts”); hard to shift risks.

• Appropriability problem: hard to keep benefits just in the hands of innovator, who pays for the fixed cost (e.g. R&D).

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Market Failures in R&D/Innovation

Special characteristics of Knowledge & K-creation: sources of market failure, hence presumption that market forces cannot render enough R&D, enough innovation (even less so for basic research).

Basic tensions:

• between incentives to innovate on the one hand, and reaping the full social benefits from innovation.

• K leaks, diffuses => good for the economy as a whole, bad for the individual inventor.

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• Secrecy

• Lead time

• Other rewards (prestige, prizes, etc.)

Those involving IPR (intellectual property rights):

• Patents (clause in the US constitution!)

• Copyrights

Mechanisms of Appropriability

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Innovation and Market Structure

• What works well for innovation - competition or monopoly?

• Static versus dynamic efficiency

• The Schumpeterian Hypothesis

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Product InnovationProduct Innovation

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Invention of a New ProductInvention of a New Product

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Social benefits from process Social benefits from process innovationinnovation

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Profits for firm that starts in competitive Profits for firm that starts in competitive market and market and gets a patentgets a patent

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Profits for monopoly firmProfits for monopoly firm

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Investment in R&D and market structure

The “value” of innovation: VS > VC > VM

Ranking could change if (then very different results throughout!):

• Monopoly can better internalize (some of the) spillovers.

• Finite effective patent and/or easier imitation for competitive firm, longer protection

for monopoly (e.g. barriers to entry).

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The question is: R&D > < Vi ? I.e. would the innovation take place?

If R&D > VS => should not innovate

• If VS > R&D > VC should innovate but markets will not.

• If VC > R&D > VM competitive markets will, monopoly will not.

• If VM > R&D both competitive markets and monopoly will innovate.

R&D and Market Structure - continued

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R&D and Market Structure – cont. 2

• Disparity between VS and VC , VM could be

much more significant if large spillovers:

(VS + spillovers) >> VC , VM

=> main determinant of policy

• Room for government intervention, e.g. subsidize R&D – see Chief Scientist Programs in Israel; see Vaanevar Bush, “Science: The Endless Frontier”, 1945.