The Industrial Economy: Strategy Dr Daniel Sgroi EC132: Tue 9-10am (MS0.2) / Thu 3-4pm (MS0.2) Lecture 6: Innovation Lecture 6 Last lecture Why do firms differ from one another? 1. 2. Industry factors (strategic assets) Firm specific factors (resources) Today: Innovation as a valuable source of competitive advantage The free rider problem Patents The ‘Analytical Engine’ First general purpose mechanical computer Designed by Charles Babbage in 1837 Deemed too expensive to build at the time 100 years until general purpose computers could be cost-effectively built Source: Nordhaus, William D. 2007. “Two Centuries of Productivity Growth in Computing.” The Journal of Economic History 67 (01) - (Reproduced in the CORE econ textbook) What is innovation? Two types of innovation: Product innovation: the introduction of entirely new products – (e.g. Telephone) Process innovation: the production of existing goods at lower cost – (e.g. Low cost airlines) There is less to the distinction than would appear at first sight: A process innovation lowers the cost of producing an existing good below the previous level A product innovation lowers the cost of producing a new good below some level that was previously prohibitive A Product Innovation A new product has become cheap enough to be supplied/demanded. Costs have decreased to a level consumers are willing to pay (It may have been that previous products were not desirable at any price) A Process Innovation An existing product becomes cheaper to supply. Process innovation is simply a continuation of product innovation Does Innovation Add Value to the Firm? Innovation would seem like the best guarantee of a firm’s competitive advantage. Continuous innovation -> continuous cost advantage Provides a source of product differentiation May spill over to reputation/brand Does Innovation Add Value to the Firm? But…on closer inspection it is likely to be costly, uncertain, and hard to manage May not work technically If it works, is there a market? – How elastic is demand when price falls? If it works and there is a market, can it be defended against competitors? ‘Public goods’ In competitive markets, innovation and knowledge creation are public goods Public goods are goods such that: 1. 2. They are not depleted the more people use them It is difficult to prevent others using them Production of these public goods is very often subject to free rider problems The free rider problem Firm B Invest in innovation Wait and try to copy Firm A Invest in innovation Wait and try to copy 5, 5 5, 20 20, 5 10, 10 The free rider problem A free rider problem exists. Little or no investment in innovation without a solution Q: Why is this bad for society? …Let’s consider two cases, a competitive and a monopolised industry Innovation in a Competitive Industry Effects of the innovation Costs and Prices: Down Output: Up Consumer Surplus: Up Producer Surplus: Unchanged The innovation has added no value to the firm! Innovation in a Monopolised Industry Effects of the innovation Costs and Prices: Down Output: Up Consumer Surplus: Up Producer Surplus: Up Firm has incentive to innovate Innovation We are faced with a dilemma… On the one hand: Competitive industries provide maximum total gain from innovation On the other: Monopolised industries provide firms with the much needed incentives to undertake (costly) innovation Can we have both? An idea to solve this problem: Patents Patents are government enforced temporary monopoly power! Violating a patent can be very costly for a firm Apple v. Samsung Patent war waged since 2011 – Multiple jurisdictions – Many competing claims and counter-claims Apple’s main claim is Samsung copied physical design and design of menu Apple v. Samsung Judges in US ruled in favour of Apple in 2012 ($1.05bn) Series of appeals, currently with Supreme Court – (Oct. 2016) Rulings in favour of Samsung in Korea, Japan and UK Patents may encourage innovation …But they also bring new problems Problems with patents – – – – – – – – Costs of litigation Length Breadth Patent races Can all ideas be patented? Should all ideas be patented? Ethical issues Patent trolls (all to be discussed in Seminar 2) Optimal patent length Q: How long should a patent last? A: Long enough to incentivise innovation …but not prolong monopoly power Optimal patent length But, how do we determine true costs? Usually private information. Profit Patent -> Monopoly profit Time Imitators enter Cost of the innovation Would we trust firms to report them? Patent races Firm B Invest in innovation Do not invest Firm A Invest in innovation Do not invest 0, 0 100, 10 10, 100 10, 10 Can all ideas be patented? E.g. Restaurant Industry Menu and signature dishes are a major source of competitive advantage But a restaurant’s menu cannot be patented! However, chefs around the world continue to be innovative Why? – Tacit knowledge – Fast moving product line – Relational contracts? Should all ideas be patented? E.g. Software industry Innovation occurs organically without patents (open source software) Software innovations are strongly complementary with other innovations – Restricting diffusion may limit innovation elsewhere Software patents often broad and abstract, vagueness can lead to ‘patent wars’ and costly litigation Other solutions to secure innovations Company secrecy – (e.g. Coca-Cola) Resources which allow firms to bring an innovation to market quicker than competitors – (e.g. superior sales force) Lecture 6 Today Innovation as a valuable source of competitive advantage The free rider problem Patents Next lecture Is the firm in the right market?