4820–10
R&D
Geir B.
Asheim
Research and development
Introduction
Process
innovation
4820–10
Patent
races
Welfare
analysis
Geir B. Asheim
Strategic
adoption
Department of Economics, University of Oslo
Network
externalities
ECON4820
Spring 2010
Last modified: 2010.03.23
New products or reduced cost of existing products?
4820–10
R&D
Geir B.
Asheim
Introduction
Outline
Process
innovation
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
How will the market look like in the future?
Which firms?
Which products?
What production technology?
Depends on:
Entry deterrence
Regulation
Innovation
...
Two kinds of innovation:
Product innovation (special case of process innovation?)
create new goods and services
Process innovation
reduce costs of existing services
Outline
4820–10
R&D
Geir B.
Asheim
Introduction
Outline
Process
innovation
Patent
races
Process innovation
Social value under perfect competition
Private value under monopoly
Private value under competition
Private value under monopoly threatened by entry
Welfare
analysis
Introduction to patent races
Strategic
adoption
Welfare analysis of patent protection
Network
externalities
Strategic adoption of new technologies
Network externalities
Process innovation:
reduced cost of existing products
4820–10
R&D
Geir B.
Asheim
What is the value of an innovation
for society?
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
for an innovating firm?
It depends on the situation:
Is the innovation patent-protected (forever)?
Competition or monopoly before the innovation?
Welfare
analysis
Strategic
adoption
Network
externalities
Throughout we will assume:
Constant unit costs
The innovation decreases costs from c to c
Social value under perfect competition
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
Value for a social planner
c
s
Per time period: v = c D(p)dp
∞
Present value: V s = 0 e −rt v s dt = 1r v s =
c
c
D(p)dp
Corresponds to the situation where there is
perfect competition
no patent-protection
Welfare
analysis
Private value in this situation: 0
Strategic
adoption
Issues: Role of
Network
externalities
1
r
monopoly and
patent-protection
in providing incentives for innovation
Private value under monopoly
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
Assumption: Monopoly before and after the innovation
Πm (c) = maxp Π(p, c) , where Π(p, c) ≡ (p − c)D(p)
p m (c) = arg maxp Π(p, c)
Private value in this situation measured by change in Πm (c):
dΠm (c)
dc
=
∂Π(p m (c),c) dp m (c)
∂p
dc
+
∂Π(p m (c),c)
∂c
=−D(p m (c))
=0
Per time period:
c
v m = Πm (c) − Πm (c) = − c
Present value: V m = 1r v m =
c
dΠm (c)
m
dc
=
dc
c D(p (c))dc
1 c
m
s
r c D(p (c))dc < V
Social value: Add value of expanded output
Private value under competition
with patent protection
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
Suppose all firms in the market have constant unit costs c
Homogenous product, price competition: p = c, Π = 0
One firm makes an innovation, lowering its cost to c
The innovation is protected by a patent of infinite duration
Two cases to consider:
(i) The innovation is drastic: p m (c) ≤ c
Even at the monopoly price,
the innovating firm undercuts its competitors
(ii) The innovation is non-drastic: p m (c) > c
The innovating firm serves the whole market
by charging (slightly less than) c
Private value of a non-drastic innovation
4820–10
R&D
Geir B.
Asheim
Per time period: v c = (c − c)D(c)
Present value: V c = 1r v c = 1r (c − c)D(c)
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
∀c > c, p m (c) > p m (c) > c
⇒ ∀c > c, D(p m (c)) < D(c)
⇒ Vm < Vc
∀c < c, D(c) < D(c)
⇒ Vc < Vs
Conclusion: V m < V c < V s
Social value: Add nothing
This ranking also holds for a drastic innovation
Social value: Add value of expanded output
Replacement effect of an innovation (Arrow, 1962)
4820–10
R&D
Geir B.
Asheim
Why is V m < V c ?
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
In the competition case,
the innovating firm escapes a zero-profit situation
In the monopoly case,
the innovating firm replaces one monopoly situation
with another
Because of the replacement effect,
competition is good for the firms’ incentives to innovate
Private value under monopoly threatened by entry
with patent protection
4820–10
R&D
Assumption: The entrant innovates if the monopolist does not
Geir B.
Asheim
This increases the monopolist’s incentives to innovate,
since now the alternative is worse
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
Πd (c1 , c2 ) — profit per period in a duopoly
when own cost is c1 and rival’s cost is c2
Private values if monopolist innovates:
Monopolist: Πm (c)
Entrant: 0
Private values if entrant innovates:
Monopolist: Πd (c, c)
Entrant: Πd (c, c)
Private value of innovation for monopolist
Πm (c) − Πd (c, c)
Private value of innovation for entrant
Πd (c, c)
Efficiency effect
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Social
planner
Monopoly
Competition
Entry
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
Assumption: A monopolist does not make less profit than two
non-colluding duopolists:
Πm (c) ≥ Πd (c, c) + Πd (c, c)
Reasonable in a homogeneous-good industry
Because of the efficiency effect,
monopoly is good for
the monopolist’s incentives to innovate
Introduction to patent races
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
Two firms, an incumbent and an potential entrant,
fight to be first to make an innovation protected by a
patent of infinite duration
The more valuable the innovation is for the incumbent,
the more resources it spends on being first, and the greater
is the probability that it will win the race and get even more
control over the market
If the efficiency effect dominates the replacement effect
(i.e., V m > V c ), then
the incumbent gets even more control over the market
In the opposite case (i.e., V c > V m ), then
the entrant takes over, at least in expectations
Welfare analysis of patent protection
in the case of product innovation
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
With infinitely long-lived patents, a firm can have
too little incentive to engage in R&D,
due to the appropriability effect
(the private surplus is lower than the social surplus)
too much incentive to engage in R&D,
due to the business stealing effect
(the profit lost by competitors is not internalized)
What is the optimal degree of patent protection?
Why is it important to prevent imitation?
Imitation by competitors reduces the profit of the innovator
Imitation increases the competitors’ profit,
allowing them to “free-ride”
Strategic adoption of new technologies
4820–10
R&D
Geir B.
Asheim
Consider a technology without patent protection,
but where adoption is costly.
Adoption decreases costs from c to c. Assume that D(c) = 1.
Introduction
Process
innovation
Patent
races
Welfare
analysis
Strategic
adoption
Adoption w/o
strategic considerations
Adoption w/
strategic considerations
Network
externalities
Private value of adoption if the competitor does not adopt:
Per time period: v = (c − c)
Present value: V = 1r v = 1r (c − c)
Adoption costs are decreasing over time: C (t)
C (0) very high, C (t) < 0, C (t) > 0
Net present value of being a technology leader, adopting at t:
L(t) = (V − C (t))e −rt
The follower does not adopt: F (t) = 0 for all t
Adoption without strategic considerations
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Patent
races
Let the leader be picked out in advance
The leader maximizes L(t):
FOC: 0 = L (t) = −C (t)e −rt − r (V − C (t))e −rt
gain of delay
Welfare
analysis
Strategic
adoption
Adoption w/o
strategic considerations
Adoption w/
strategic considerations
Network
externalities
cost of delay
C (t ∗ ) = V + 1r C (t ∗ ) < V
Define t c by L(t c ) = 0
Since C (t c ) = V and C (t ∗ ) < V , it follows that t c < t ∗
Adoption with strategic considerations
4820–10
R&D
Geir B.
Asheim
Let both firms consider technology adoption
Introduction
Process
innovation
A firm never adopts before t c
Patent
races
A firm preempts if the other adopts after t c
Welfare
analysis
Equilibrium: Adoption by one firm at time t c
Strategic
adoption
Adoption w/o
strategic considerations
Adoption w/
strategic considerations
Network
externalities
Rent dissipation
Wastefulness
Network externalities
4820–10
R&D
Geir B.
Asheim
Introduction
Process
innovation
Patent
races
Welfare
analysis
Strategic
adoption
Network
externalities
Positive externalities between consumers
Examples: Telephone, fax, e-mail, etc.
More generally: Network effects
Examples: System goods, such as
computers and software
video cassette recorders and video cassettes
When a new technology is available,
each consumers must decide whether to switch
A coordination problem: The more consumers switching,
the higher is the utility from switching
Excess inertia: Consumers wait longer than what is
socially optimal because no-one want to be first to switch
to the new technology
Excess momentum: Consumers switch too early because
they do not want to be left with the old technology