EconS 425 - Innovation

EconS 425 - Innovation

Eric Dunaway

Washington State University

[email protected]

Industrial Organization

Eric Dunaway (WSU) EconS 425 Industrial Organization 1 / 38

Introduction

Today, we�re going to talk about Research & Development.

Investing in new technologies is critical for �rms to retain their marketpower.If they don�t, they�ll eventually be challenged by entrants who can beatthem at their own game.

The question remains, however: How much should a �rm invest ininnovation?


Innovation

Let�s look at a couple of examples of Research and Development:

A decade after World War II, the US economy was booming.

The war economy had completed its transition into a manufacturingeconomy, and the wealth of the middle class was exploding.This caused the demand for cars to increase; families wanted to ownvehicles to take on road trips on the newly completed interstate system.

The major US car manufacturers Ford, Dodge, and Chevrolet allenjoyed strong oligopoly pro�ts during this time.

Very little was invested in cost saving technology, however, and careprices were higher because of this.


Innovation

At the same time, the Japanese economy was starting to recover fromWorld War II.

Unlike the US economy, the Japanese manufacturing sector wasdevastated during World War II; it essentially had to be rebuilt fromscratch.While rebuilding, the Japansese made signi�cant investments in theirproduction process, speci�cally in making steel.

By the late 1970s, Japanese companies Toyota, Honda, Subaru, etc.had developed product that were not only higher quality than theirUS counterparts, but also cheaper.

They decided it was time to enter the US market.


Innovation

When these Japanese cars were introduced to the US market, USconsumers were furious.

Not so much at the Japanese cars, but moreso at the USmanufacturers.Decades of stagnant innovation made it so that the US manufacturerscouldn�t even compete with their Japanese rivals.

The US manufacturers completely lost their dominant position, andscrambled to innovate, themselves.

They eventually were able to match the technology that the Japanesemanufacturers had, but they never fully recovered their market share.Entry was not deterred.


Innovation

This is an example of research in Research & Development.

Firms are constantly looking for ways to reduce their costs in order toincrease their competitiveness.Ford, Dodge, Chevrolet, and other US manufacturers learned a veryimportant lesson in the 1970s: if you stagnate, you get replaced.

Let�s look at an example of development:

Development is how new innovations are adapted for sale to a market.


Innovation

In 1982, Stan Lee was on a business trip to Japan when he watchedan episode of Taiyo Sentai Sun Vulcan, a show about teenagers whocould turn into superheroes and �ght against monsters.

Stan Lee wanted to bring this show to the US market, as it remindedhim of his own X-Men comics: empowered teens that make a di¤erence.The show was already airing in small US television markets with largeJapanese populations, and it was extremely popular.

Lee worked with Maggie Loesch, a former executive atHanna-Barbera, and they dubbed the show in English and pitched itto several networks.

Every single network rejected the show, as they believed it was tooviolent.In 1985, Stan Lee relinquished the US rights to the show.


Innovation

A few years later, music producer Haim Saban was also doing work inJapan when he saw a later season of the same series.

He also had a US pilot produced, and again, it was rejected by all ofthe major television networks.

At this point, Maggie Loesch had moved on to work for FoxEntertainment, a new network that was trying to establish a morningprogramming bloc that would appeal to young boys, in particular.

Due to her familiarity with the material, Loesch convinced the top Foxexecutives to green light Saban�s venture with this new show.


Innovation

To adapt this show for the US market, they decided that instead ofdubbing it, they would "remix" it of sorts, to make the plot lines easyto understand for American children.

They spliced action scenes from the most recent season of the show,Kyoryo Sentai Zyuranger, into new stories with American actors.

Again, however, they received signi�cant pushback from executivesand parent groups who thought the show was much too violent.

They ran focus groups with their target audience to see if the productactually appealed to them.

The data was o¤ the chart; no show had ever scored this high before.It scored so high that the executives were sure that something waswrong in the data collection process.


Innovation

Some of the major Fox a¢ liates refused to even show the pilot due tothe violence.

Loesch held strong, however, and in September of 1993, the �rstepisode of Mighty Morphin Power Rangers aired.It turns out that the data was correct, as the reaction from their targetaudience bordered on hysteria.

For the next few years, Power Rangers and its knocko¤s dominatedthis demographic of the morning/afternoon entertainment market.

All of the networks that turned down the original pilot were scramblingto �nd something to compete against Power Rangers.


Innovation

This is a great example of how challenging it can be to convert aninnovation into a new product.

Neither Loesch, nor anyone who worked on the show (including theactors) had any certainty that their venture was going to be successful,but they persisted.In return, they were rewarded with �rst-mover advantage in a newmarket.


Innovation

Research & Development is a great exercise in costs and bene�ts.

Naturally, the bene�ts to R&D can be huge; in some cases one �rmcan get a competitive edge on their rivals, and in some cases, theycan push their rivals out of the market entirely.

On the other hand, R&D takes signi�cant time and money, and maynot be successful.

Furthermore, when a �rm creates a new innovation, their oldinnovations may become obsolete and worthless. That could potentiallybe a lot of capital that the �rm is throwing away.This is known as creative destruction, and can disincentivize �rms frominnovating at all.


Innovation

In general, we break Research & Development into three broadcategories:

Basic research: General improvements on our knowledge of aninnovation. For example, researching laser technology.Applied research: Turning innovations into useful things. For example,creating a laser drill for dentists.Development: Turning our useful thing into something a �rm can massproduce and sell. For example, optimizing that laser drill and gettingdentists to test it and give feedback.

Primarily, we are interested in the applied research portion the most,as it has the potential to change the most in a market.


Innovation

Among innovations, we also like to categorize them in two ways:drastic, and nondrastic.

A drastic innovation is such that if a �rm were competing with a rivalbefore and it receives a new innovation, the innovating �rm is able toprice such that their monopoly price is lower than the rival �rm�smarginal cost; e¤ectively pushing their rival out of the market.A nondrastic innovation simply gives the innovating �rm a competitiveedge over its rival, but does not drive them out of the market.

For example, if we had a case of Bertrand competition, and each �rminitially had a marginal cost of cH ; if a drastic innovation causes one�rm�s monopoly price to be less than cH , the other �rm would beforced to exit the market.


Innovation

Likewise, if �rms competed in quantities (Cournot) with a standardlinear demand function

q = a� bpand one �rm was able to lower its constant marginal cost from cH tocL through innovation, if

pM =a+ bcL

2b< cH

cL < 2cH � ab

then the rival �rm can�t sell anything for a pro�t, e¤ectively drivingthem out of the market.


Innovation

How are innovations valued?

This is probably the biggest question economists are interested in.Naturally, we should expect that di¤erent groups value innovationsdi¤erently.

Suppose we had a market where aggregate demand is some functionq = D(p) and marginal costs are constant at cH . One of the �rmshas the option of paying a price of K to innovate, lowering theirmarginal cost to cL.

We�ll also give them patent protection, to other �rms cannot inventaround their patent.Furthermore, we�ll assume that the innovation is nondrastic, so none oftheir rivals are forced to exit the market.


Innovation

First, let�s look at how a social planner would value an innovation.

Remember that a social planner is basically a benevolent dicatator (i.e.,Kim Jong Un if you gave him a Snickers). Their whole goal is tomaximize total welfare.Welfare being either consumer or producer surplus.

We can calculate the valuation to the social planner as how muchwelfare increases from the high cost to the low cost.


Innovation

q*

D(p)

cH SCS

q

p


Innovation

q*

D(p)

cL S

cH CS

q

p


Innovation

q*

D(p)

cL S

cH

Welfare Gain

q

p


Innovation

What if we had two �rms that competed in prices. How would theinnovating �rm value that innovation?

Naturally, the �rm is only interested in their pro�ts, the producersurplus. Thus, their valuation would be the increase in producersurplus.

Since this innovation to nondrastic, a low cost innovating �rm can�tcharge their monopoly price.

They can, however, undercut their high cost rival by the smallestamount possible and claim all of the market and some pro�ts forthemselves.


Innovation

D(p)

cH SCS

q*q

p


Innovation

D(p)

cL S

cH

q

p

q*

CS

PS


Innovation

D(p)

cL S

cH

q

p

q*

ProfitGain


Innovation

As we can see right away, the social planner values an innovationmore than a duopolist.

Since the duopolist does not lower their price to marginal cost, thiscreates deadweight loss.To do so, however, would cause the duopolist to lose out on pro�ts,which they care about very much.

What if we had just one �rm, a monopolist in this case?

Again, like the duopolist, they value the innovation as how muchadditional pro�t it gives them.


Innovation

q*

D(p)

cH S

q

p

MR

p*CS

PS


Innovation

q*

D(p)

cH

q

p

MR

p*CS

PS

cL S


Innovation

q*

D(p)

cH

q

p

MR

p*

cL S

ProfitGain


Innovation

Like before, we see that the monopolist doesn�t gain as much fromthe innovation as either the duopolist or the social planner.

Again, they are only interested in their own pro�ts, so they don�t valuethe increase in consumer surplus at all.

Furthermore, the monopolist already had positive pro�ts before theinnovation, and creating this innovation causes the monopolist toactually lost some of their producer surplus in exchange for otherproducer surplus.

Essentially, the monopolist is making their old, pro�t earning product,obsolete, which also disincentivizes innovation.

This process is known as the replacement e¤ect, as monopolists arereluctant to replace their own existing technology.


Innovation

The above analysis is all well and good, but in the real world, wedon�t just limit the ability to innovate to one �rm.

Firms will compete among themselves to be the �rst to innovate andget that advantage. We should add that to the model.

Suppose we had an incumbent monopolist who faces entry by apotential entrant. Let�s build a game for them to play.

In the �rst stage of the game, the incumbent decides whether or not toundertake R&D.In the second stage of the game, the entrant decides whether or not toenter the market.In the third stage of the game, the entrant decides whether or not toundertake R&D.


Innovation

A few more assumptions:

Only one innovation is available, and whoever gets it �rst is protectedby a perfect patent.Without R&D, both �rms have a constant marginal cost of cH . If one�rm innovates, their marginal cost falls to cL.If the entrant stays out of the market, their pro�ts are 0. If they enter,the compete as a duopolist with the incumbent and earn πE (cI , cE ),where cI is the incumbent�s cost, and cE is the entrant�s cost.Likewise, the incumbent receives πI (cI ) if the entrant stays out andthey remain a monopolist, and πI (cI , cE ) if entry occurs and theycompete as a duopolist.


Innovation

Incumbent

EntrantEntrant

Entrant

InnovateDo Not Innovate

InnovateDo Not Innovate

Do NotEnter Enter

Do NotEnter Enter

πI(cH)0

πI(cL)0

πI(cL,cH)πE(cL,cH)

πI(cH,cH)πE(cH,cH)

πI(cH,cL)πE(cH,cL)


Innovation

Let�s �gure out how both the incumbent and the entrant valueinnovation.Starting with the entrant, let�s assume that no matter what theincumbent does, the entrant will enter the market.

If the incumbent does not innovate, the entrant can innovate andreceive pro�ts of πE (cH , cL), or they can not innovate and receivepro�ts of πE (cH , cH ). Thus, their valuation of the innovation is theincrease in pro�t they receive from innovating,

vE = πE (cH , cL)� πE (cH , cH ) > 0

Now, for the incumbent, let�s also assume that if they do notinnovate, the entrant will.

If the incumbent innovates, the entrant enters and the incumbentreceives πI (cL, cH ), and if the incumbent does not innovate, theentrant enters and innovates, leaving pro�ts for the incumbent ofπI (cH , cL). Thus, the value of innovation to the incumbent is,

vI = πI (cL, cH )� πI (cH , cL) > 0


Innovation

vE = πE (cH , cL)� πE (cH , cH )

vI = πI (cL, cH )� πI (cH , cL)

Now, let�s compare these two to see who values innovation more.Making one more assumption, we assume that if the �rms compete asa duopoly, they are symmetric, i.e., πE (cH , cL) = πI (cL, cH ). Thus,taking the di¤erence of our two valuations,

vI � vE = πI (cL, cH )� πI (cH , cL)� [πE (cH , cL)� πE (cH , cH )]

πE (cH , cH )� πI (cH , cL) > 0

This implies that the incumbent actually values the innovation morethan the entrant does.

Why? The incumbent would much rather compete against a high costentrant than a lower cost entrant, even if the innovation doesn�tprevent entry.


Innovation

On the other hand, if innovation deters entry, we would �nd that thevalue of vI � vE would actually increase.

This implies that the incumbent would value that innovation even more.Intuitively, the monopolist would rather innovate if it prevented entrythan innovate just to have a high cost competitor. Monopoly is betterthan duopoly for sure.

This is the opposite result that we saw in our �rst model.

The monopolist valued innovation more than the duopolist.We call this the e¢ ciency e¤ect. Essentially, replacing yourself is betterthan being replaced by a competitor.


Summary

Innovation allows �rms to lower their costs, and either be morecompetitive in a market, or wipe out their competition alltogether.

We classify two innovation e¤ects as the replacement e¤ect and thee¢ ciency e¤ect.

They have opposite results (for now), but they demonstrate thatdi¤erent agents in a market value innovation di¤erently.


Next Time

Resolving the replacement and e¢ ciency e¤ects.

More competition e¤ects

Reading: Chapter 15.3-15.5


Homework 7-5 (The last one!)

Elon Musk has indicated that he will not enforce his Tesla patent thatpertains to the electrical motor used to power their cars. Musk hopesthat this will encourage other �rms to pursue R&D e¤orts in theelectric car �eld. Why would Elon Musk want this to happen? (Thereare several reasons, come up with at least one)


Documents

EconS 425 - Innovation