Technology, R&D, and Efficiency
CHAPTER 13
TECHNOLOGY, R&D, AND EFFICIENCY
CHAPTER OVERVIEW
This chapter introduces students to the importance of technical advances, R&D decisions, and
innovation and brings these topics directly into the core microeconomic chapters. This chapter focuses
explicitly on the effects of market structure on technological progressiveness.
We believe that R&D and innovation are simply too important to student understanding of modern
industrial economies to disregard or relegate to a side bar. Therefore, we have integrated this material
into the main flow of the theory of the firm. The instructor, however, can bypass this chapter without
jeopardizing course continuity.
WHAT’S NEW
Most of the changes in this chapter consist of updated numbers and examples. New examples include the
Palm Pilot, the effect of the war on terrorism on R&D, the demise of the XFL football league, and
Nestlé’s recent purchase of Chef America (producer of Hot Pockets).
A “Consider This” box has been added dealing with trade secrets. It appeared on the website in the
previous edition as an “Analogies, Anecdotes, and Insights” piece.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. Distinguish between the short run, the long run, and the very long run.
2. Describe the elements of technological advance.
3. Give a specific example of invention, innovation, and diffusion.
4. Compare and contrast the historical view of technological advance with the contemporary view.
5. Evaluate the role of entrepreneurs and other innovators in technological advancement.
6. Identify and explain how a firm’s optimal amount of R&D spending is determined.
7. List the possible sources of R&D financing.
8. Explain how marginal utility theory can be used to determine the success or failure of a new
product.
9. Explain how process innovation adds to a firm’s profits.
10. Describe and give an example of the “fast-second” strategy.
11. Enumerate the protections and potential benefits for firms that take the lead with R&D and
innovation.
12. Evaluate the strengths and weaknesses of each of the four basic market structures regarding the
likelihood of R&D and innovation.
13. Describe the inverted U theory.
14. Evaluate the impact of technological advance on productive and allocative efficiency.
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15. Describe and give an example of “creative destruction.”
16. Define and identify the terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Student interest in this topic is likely to be high. Oral reports presenting recent newspaper or
magazine articles on inventions, innovations or projections of new products, new materials or new
processes should spark good discussion. Scientific American frequently devotes an issue to new
technologies within a specific industry. In addition, Discover, Popular Science, weekly news
magazines, and Business Week are all likely to feature reports on new technology.
2. Many craftsmen are natural innovators. Have the students interview someone that works in the
building trades (carpenters, tile setters, plumbers, or welders). Each construction job is different
and often special problems or conditions make doing the job a challenge. Many craftsmen have
developed unique methods and are proud of both their efficient systems and the appearance of the
finished projects. In some cases, this assignment could bring new appreciation for a parent or
other family member who operates a business.
3. Ask students to describe an incident when they were faced with a task to complete without the
proper or most convenient tools. How did they solve the problem? Did they fashion a new tool or
use a tool designed for another purpose creatively?
4. For an effective and interesting example of copyrights and trademarks, you may find the following
“Concept Illustration” useful.
Concept Illustration: Copyrights and trademarks
The board game Monopoly is an interesting example of a patented, trademarked product that is
still earning a substantial profit after many decades.1 The word “monopoly” goes back hundreds
of years, but Monopoly (the game) is the registered trademark of Parker Brothers, now a unit of
Hasbro.
The origin of modern Monopoly traces to Elizabeth Magie, a Quaker from Virginia. She invented
the game in 1904 to advance the cause of Henry George, who advocated a single tax on land rent.
Like Monopoly, Magie’s game had forty spaces, four railroads, two utilities, and twenty-two rental
properties. The folk game was commonly played on the eastern seaboard, particularly within
Quaker communities. The streets in the game were named after those between Inlet and Park
Place, along the Boardwalk in Atlantic City.2
In the early 1930s, Charles Darrow of Germantown, Pennsylvania, copied and commercialized the
game, selling it through Philadelphia department stores. Demand was so great that he could not
keep up with the orders, so in 1934 he contacted Parker Brothers, a toy company, to see if they had
any interest in it. Parker Brothers initially rejected the game, pointing out that it lasted too long,
had rules that were too complicated, and contained fifty-two fundamental design errors. But
Monopoly continued to sell briskly in Philadelphia. F. A. O. Schwarz, a New York toy store,
ordered 200 sets of Monopoly from Darrow.
Legend has it that a friend telephoned Sally Barton, the daughter of the founder of Parker Brothers,
to rave about a new game she had purchased at the New York store. It was called Monopoly.
Sally relayed the information to her husband, Robert Barton, who was president of Parker
Brothers. Barton purchased a copy of the game the next day and ended up playing Monopoly until
1:00 A.M. The next morning, he contacted Darrow and several days later Darrow agreed to sell
the rights to his version of the game in return for royalties on each set sold.
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Through copyright and trademark, Parker Brothers in effect gained a worldwide monopoly on
Monopoly (although “The Original Monopoly Game” is an alternative3). Monopoly is available in
26 languages in 80 countries and is the best-selling copyrighted board game ever. More than 200
million sets have been sold, generating more than $3 billion of revenue for Parker Brothers.
Maxine Brady, “The Monopoly Book: An Authorized History,” Internet; “Hasbro/Parker
Brothers, “Monopoly History,” Internet; “History of Toys and Games,” History Channel, Internet
site.
2
Ralph Anspach, the developer of the game Anti-Monopoly—and later, the Original Monopoly
Game—uncovered this history of Monopoly (the game) in defending Anti-Monopoly in a court
case relating to Parker Brother’s trademark. See his The Billion Dollar Monopoly Swindle
(San Francisco: Anspach Publication, 1998).
3
Ibid.
1
LECTURE NOTES
I.
Technological Advance: Invention, innovation, and diffusion.
A. In the short run it is assumed that technology, plant, and equipment are constant. In the long
run, the size of the plant can change and firms can enter or leave the industry; in the very
long run, technological advances can occur.
B. Technological advance is a three-step process that shifts the economy’s production
possibilities curve outward, enabling more production of goods and services.
1. The most basic element of technological advance is invention: The discovery of a
product or process and the proof that it will work.
2. Innovation is the first successful commercial introduction of a new product, the first use
of a new production, or the creation of a new form of business enterprise.
3.
Diffusion is the spread of innovation through imitation or copying.
C. Expenditures on research and development include direct efforts by business toward
invention, innovation, and diffusion. Government also engages in R&D, particularly for
national defense.
1. In 2002 total U.S. R&D expenditures (business plus government) were $292 billion, 2.79
percent of U.S. GDP. (See Global Perspective 26-1 for comparison.)
2. American business spent $211 billion on R&D in 2002. (See Figure 26-1 for breakdown
into categories.)
D. The modern view of technological advance.
1. For decades economists treated technological advances as an element largely external to
the market system — a random outside force to which the economy adjusted.
2. Contemporary economists see capitalism itself as the driving force of technological
advance, providing the incentives and motives for firms and individuals to seek
profitable opportunities.
II.
The role of entrepreneurs and other innovators.
A. The entrepreneur is an initiator, innovator, and risk bearer—the catalyst who uses resources
in new and unique ways to produce new and unique goods and services.
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B. Other innovators, who do not bear personal financial risk, include key executives, scientists,
and others engaged in commercial R&D activities.
C. Often entrepreneurs form new companies called “start-ups”, i.e., firms that focus on creating
and introducing new products or employing a specific new production or distribution
technique.
D. Innovators are also found within existing corporations supported by working conditions and
pay incentives that foster creative thinking. Some firms have chosen to “spin off” the R&D
function into new, more flexible and innovative companies.
E. Product innovation and development are creative endeavors with intangible rewards of
personal satisfaction, but the “winners” can also realize huge financial gains. Success gives
entrepreneurs and innovative firms access to more resources. The entrepreneurs are found in
many different countries around the world.
F. Technological advance is supported by the scientific research of universities and government
sponsored laboratories. Firms increasingly help to fund university research that relates to
their products.
III.
The firm’s optimal amount of R&D.
A. Finding the optimal amount of R&D is an application of basic economics.
1. To earn the greatest profit, a firm should expand a particular activity until its marginal
benefit equals its marginal cost.
2. The R&D spending decision is complex because the estimation of future benefits is
highly uncertain while costs are immediate and more clear cut.
B. Interest rate cost of funds: Whatever the source of R&D funds, the opportunity cost of these
funds is measurable by the current rate of interest. (See Figure 26-2.) Possible sources
include the following:
1. Bank loans
2. Bonds
3. Retained earnings
4. Venture capital
5. Personal savings
C. A firm’s marginal benefit from R&D is its expected rate of return on the expenditures. The
curve showing the expected rate of return slopes downward because of diminishing returns to
R&D expenditures. (See Figure 26-3.)
D. Optimal R&D expenditures occur when the interest rate cost of funds is equal to the
expected rate of return. (See Figure 26-4.)
1. Many R&D expenditures may be affordable but not worthwhile because the marginal
benefit is less than the marginal cost.
2. Expenditures are planned on the basis of expected returns. R&D decisions carry a great
deal of risk. There is no certainty of outcome.
IV.
Increased profit via innovation.
A. Increased profit via product innovation.
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1. Consumers will buy a new product only if it increases the total utility they obtain from
their limited incomes. They purchase products that have the highest marginal utility per
dollar. (Review Chapter 21 and Table 21-1.)
a. Consumer acceptance of a new product depends on both marginal utility and price.
b. The expected return that motivates product innovation may not be realized.
Expensive ‘“flops” are common.
c. Most product innovation consists of incremental improvements to existing products
rather than radical inventions.
B. Reduced cost via process innovation.
1. Firms can increase output by introducing better production methods or by using more
productive capital equipment.
2.
V.
An innovation that increases total product at each level of resource usage lowers the
average total cost of a unit of output and thus enhances the firm’s profit. (Figure 26-5)
Imitation and R&D Incentives
A. A firm’s rivals may deliberately employ the “fast-second strategy,” allowing the originating
firm to incur the high costs of R&D and then entering quickly if the product is a success.
B. There are protections, potential advantages, and benefits of being first.
1. Some technological breakthroughs can be patented; they cannot be legally imitated for
two decades. (See Global Perspective 26-2.) Many holders of U.S. patents are citizens
or firms of foreign nations.
2. Copyrights and trademarks reduce the problem of direct copying.
Illustration on Monopoly game.)
(See Concept
3. Along with trademark protection, brand name recognition may give the original
innovator a marketing advantage.
4. Trade secrets may prevent imitation of a product, and sometimes it is the process that is
the key to success. The originating firm may also gain an advantage simply by learning
on the job. CONSIDER THIS … Trade Secrets
5. Time lags between innovation and diffusion often permit originating firms to realize a
substantial economic profit.
6. A final advantage of being first is the potential for an attractive buyout offer. This
allows innovative entrepreneurs to take their rewards immediately without the
uncertainty of production and marketing on their own.
7.
VI.
There continue to be high levels of R&D that would not be the case if imitation
consistently and severely depressed actual rates of return on these expenditures. (See
Figure 26-6.)
Role of Market Structure
A. Market structure and technological advance.
1. Pure competition—Although purely competitive firms may have an incentive to keep
ahead of their competitors, the small size of the firms and the fact that there are no
barriers to entry and therefore they can earn only a normal profit in the long run, leads to
serious questions as to whether such producers can benefit from and finance substantial
R&D programs.
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2. Monopolistic competition—There is a strong profit incentive to engage in product
development in this market structure. However, most firms remain small, which limits
their ability to secure financing for R&D. Economic profits are usually temporary
because there are few barriers to entry.
3. Oligopoly—The oligopolistic market structure is conducive to technical advance. Firms
are large with ongoing economic profits, are protected by barriers to entry, and have
large volume of sales. Although oligopolistic firms have the financial resources to
engage in R&D, they are often complacent.
4. Pure monopoly—Pure monopolists have little incentive to engage in R&D. Since profits
are protected by absolute barriers to entry, the only reason for R&D would be defensive,
i.e., to reduce the risk of a new product or process that might destroy the monopoly.
B. Inverted-U Theory (Figure 26-7)
1. The inverted U suggests that both very low-concentration industries and very highconcentration industries expend a relatively small percentage of their sales revenue on
R&D.
2. The optimal market structure for technological advance seems to be an industry in which
there is a mix of large oligopolistic firms (a 40 to 60 percent concentration ratio) with
several highly innovative smaller firms.
3. Competitive firms are small, which makes it difficult for them to finance the R&D, and
there is easy entry by competitors. Where firms have a substantial amount of monopoly
power, monopoly profits are large and innovation will likely not add much more to the
firm’s profits.
4. The level of R&D spending within an industry seems to be determined more by the
industry’s scientific character and “technological opportunities” than from its market
structure.
VII.
Technological Advance and Efficiency
A. Productive efficiency is improved when a technological advance involves process innovation
and a reduction in costs. (See Figures 26-5a and b.)
B. Allocative efficiency is improved when a technological advance involves a new product that
increases the utility consumers can obtain from their limited income.
C. Innovation can create monopoly power through patents or the advantages of being first,
reducing the benefit to society from the innovation.
D. Innovation can also reduce or even disintegrate existing monopoly power by providing
competition where there was none. In this case, economic efficiency is enhanced because the
competition drives prices down closer to marginal cost and minimum ATC.
E. Creative destruction occurs when the innovation of new products or production methods
destroys the monopoly positions of firms committed to existing products and their old ways
of doing business.
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