CHAPTER 26
Technology, R&D, and Efficiency
LECTURE NOTES
I.
II.
III.
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 2000 total U.S. R&D expenditures (business plus government) were $264 billion, 2.64 percent of U.S.
GDP. (See Global Perspective 26.1 for comparison.)
2. American business spent $199 billion on R&D in 2000. (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.
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.
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.
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 clearcut.
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IV.
V.
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.
Increased profit via innovation.
A. Increased profit via product innovation.
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. 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. (See 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.
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.
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 the innovative
entrepreneur to take their rewards immediately without the uncertainty of production and marketing on
their own.
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VI.
VII.
VIII.
7. 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.
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 high concentration
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 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.
Technological Advance and Efficiency
A. Productive efficiency is improved when a technological advance involves process innovation and a reduction
in costs. (Figure 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.
Last Word: On the Path to the Personal Computer and Internet
Technological advance is clearly evident in the development of the modern personal computer and the emergence
of the Internet. This is a brief history of these events.
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Chapter 29: LECTURE NOTES
RENT, INTEREST, AND PROFITS
I.
II.
Introduction
A. Emphasis in previous two chapters was on labor markets, because wages and salaries account for about 70
percent of our national income. (If proprietors’ income, which is largely labor income, is added to wages and
salaries, the return to labor increases to 80 percent.)
B. This chapter focuses on the other three sources of income—rent, interest, and profits—which compose the
remaining 20 percent of our national income.
C. This chapter will answer each of the following questions:
1. Why do different parcels of land in different locations receive different rent payments?
2. What factors determine interest rates and causes interest rates to change?
3. What are the sources of profits and losses and why do profits and losses change over time?
Economic rent is the price paid for use of land and other natural resources that are fixed in supply. (Note
that this definition differs from the everyday use of the term.)
A. As presented in Chapter 27, the demand for land is downward sloping because of diminishing returns and the
fact that producers must lower the price of the product to sell additional units of output.
B. Perfectly inelastic supply of the resource is one unique feature of the supply side of the market that
determines rent. Land has no production cost; it is a “free and nonreproducible gift of nature.” Its quantity
does not change with price (with a few exceptions).
C. Changes in demand therefore determine the amount of rent. This will be determined by several factors. (See
Figure 29.1)
1. The price of the product grown on the land,
2. The productivity of the land, and
3. The prices of other resources combined with the land for production.
D. Land rent is viewed as a surplus payment because it performs no incentive function to provide more supply; it
is not necessary to ensure the availability of land.
E. Some argue that rent should be taxed away, since it is unearned, or that land should be nationalized and
owned by the state.
1. Henry George’s proposal for a single tax of up to 99 percent of land rent asserted that this tax could
eliminate other taxes. Unlike the effect of a tax on other resources, the tax on land would not have a
negative incentive effect.
2. Critics of the single-tax idea make several points.
a. Current levels of government spending are too great to be supported by rent taxes.
b. It is difficult to separate the rent component from other income resulting from the combined use of
land with other resources.
c. Unearned income goes beyond land and land ownership; capital gains and interest income might also
be considered unearned.
d. It is unfair to tax current owners, who may have paid a steep market price for the land and therefore
find that the rent return is not high relative to that price.
E. Each parcel of land is not equally productive. More productive land will be in great demand and therefore
will receive different rents. These different rent payments allocate land to its most productive use.
F. In reality, land has alternative uses and costs. From society’s perspective, rent is a surplus; but an individual
firm must pay rent to attract the land away from alternative uses. Without rent to allocate land among its
various uses, there would be no market mechanism to make sure each piece of land was being utilized in its
most valuable fashion. Therefore, rent does provide an important function to our economic system.
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III.
Interest is the price paid for the use of money. It is usually viewed as the money that must be paid for the
use of one dollar for one year.
A. Two aspects of interest are important.
1. It is stated as a percentage, and the Truth in Lending Act of 1968 requires lenders to state the costs and
terms of consumer credit in terms of an annualized interest rate.
2. Money itself is not an economic resource, but it is used to acquire capital goods, so in hiring money
capital, businesses are ultimately buying the use of real capital goods.
B. The loanable funds theory of interest.
1. The supply of loanable funds is an upward-sloping curve—a larger quantity of funds will be made
available at high interest rates than at low interest rates. Most individuals prefer present consumption and
must be paid to defer consumption by saving.
2. The demand for loanable funds is inversely related to the rate of interest. At higher interest rates fewer
investment projects will be profitable since fewer projects yield the high rate of return needed to
compensate for the high interest cost.
3. Economists disagree about the responsiveness of the quantity of investment funds supplied to changes in
interest rates. Most economists believe that saving is relatively insensitive to interest rate changes and
believe the supply of funds is inelastic.
4. Whether the curves are elastic or inelastic, the equilibrium interest rate equates the quantities of loanable
funds supplied and demanded. (See Figure 29-2)
5. Households rarely lend savings directly to businesses. Households place their savings in financial
institutions and receive an interest payment. Businesses borrow funds from financial institutions and pay
an interest payment.
6. Changes in the supply of funds may occur as a result of changes in tax policy or social insurance benefits.
7. Anything that changes the rates of return on potential investments, such as improvements in technology
or a decrease in the demand of the final product, will change the demand for funds.
8. Both households and businesses operate on both the supply and demand sides of the market for loanable
funds. While households supply loanable funds, they may also borrow to finance large purchases and
education. Similarly, businesses may save in the market for loanable funds, and governments may
borrow to finance deficits.
C. Banks and other financial institutions not only gather and make available the savings of households, but also
create funds through the lending process.
D. There are many different interest rates with different names and they vary for many reasons. (See Table 29.1)
1. Varying degrees of risk (riskier loans carry higher rates),
2. Differing maturities on the loan (higher rates usually on longer-term loans),
3. The size of the loan (larger loans have lower rates),
4. Taxability (interest on some local and state bonds is tax-free; the interest would be lower, since lenders
don’t have to pay federal taxes on that interest income),
5. Market imperfections play a role, because some banks in smaller towns have more market power than
banks that have a lot of competition.
E. Economists usually refer to what is called the “pure rate of interest,” which is best approximated by the
interest paid on long-term, riskless bonds such as the long-term bonds of the U.S. government. In spring 2001
this rate was 5.5 percent. The current rate can be found in the third section of the daily Wall Street Journal
and other publications.
F. The role of the interest rate is important because it affects both the level and composition of investment and
R&D spending.
1. The level of investment varies inversely with the interest rate. The Federal Reserve System will increase
and decrease the money supply and thus influence interest rates. Changes in investment will affect the
level of GDP.
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IV.
V.
VI.
2. Interest rates will also have an effect on borrowing for R&D. Again, R&D depends upon the cost of
borrowing money as compared to the expected rate of return on the R&D project.
3. Nominal interest rates are those stated in terms of current dollars; the “real” interest rate is the rate of
interest expressed in terms of dollars of constant or inflation-adjusted value. The real interest rate is the
nominal rate minus the rate of inflation.
5. It is the real interest rate, not the nominal rate, that businesses should consider in making their investment
and R&D decisions.
G. Application: Usury laws specify maximum interest rate that can be charged on loans. The purpose is to make
borrowing more accessible to low-income borrowers. However, Figure 29-2 demonstrates several problems
with usury laws.
1. There will be a shortage of credit if the usury rate is below the market rate. Riskier borrowers may be
excluded from borrowing from established financial institutions.
2. Credit-worthy borrowers will be able to borrow at below-market “prices.”
3. Lenders will receive less than market rates of return on the funds loaned.
4. Funds will not be allocated to their most efficient use.
Economic profits are what remains of a firm’s total revenue after it has paid individuals and other firms
for materials, capital and labor supplied to the firm (the explicit costs) and allowed for payment to
self-employed resources (the implicit costs).
A. The role of the entrepreneur is most important in a capitalist economy. Profits are the reward paid for
entrepreneurial ability, which includes taking initiative in combining resources for production, making
nonroutine policy decisions, introducing innovations in products and production processes, and taking risks
associated with the uncertainty of all of the above functions.
1. A normal profit is the minimum required to retain the entrepreneur in some specific line of production.
2. An economic profit is any profit above the normal profit. This residual profit also goes to the
entrepreneur. This residual profit does not exist under pure competition in a static economy. It occurs
because of the dynamic nature of real-world capitalism and the presence of monopoly power.
B. There are several sources of economic profits, but they would not occur in a static, unchanging economy.
Thus, the first prerequisite is that the economy be dynamic.
1. In a dynamic economy, the future is uncertain and some risks cannot be insured against.
2. Uninsurable risks stem from three general sources:
a. Changes in the general economic environment
b. Changes in the structure of the economy; and
c. Changes in government policy.
3. Some or all of the economic profit in a real, dynamic economy may be compensation for risk taking.
4. Some of the economic profit may be compensation for dealing with the uncertainty of innovation.
5. Monopoly power is a less desirable source of economic profits because such profits stem from a
misallocation of resources.
C. The functions of profits include the following:
1. The expectation of profits encourages firms to innovate, which stimulates new investment. This will
expand output and employment.
2. Profits allocate resources among alternative lines of production. Resources leave unprofitable ventures
and flow to profitable ones, which is where society is signaling it wants these resources to be allocated.
Labor income is the dominant type of income, with wages and salaries constituting about 70 percent of
national income. If one adds in a part of proprietors’ income, which is probably largely labor income, the
share rises to about 80 percent. Therefore, the “capitalists’” share of income is only about 20 percent.
These percentages have remained remarkably stable in the U.S. since 1900.
LAST WORD: Determining the Price of Credit
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A. To determine the interest rate, one compares the interest paid with the amount borrowed: If you borrow
$10,000 and agree to repay that amount plus $1,000 at the end of the year, the interest rate is 10 percent.
r  $1,000 / $10,000  10%
B. In some cases a lender will discount the interest payment at the time the loan is made, so the borrower would
pay the $1,000 and receive the remaining $9,000 for an 11 percent rate of interest.
r  $1,000 / $9,000  11%
C. In other cases the financial institution uses a 360-day year instead of 365 days to calculate the interest rate,
because it is simpler to calculate monthly rates (twelve 30-day months), but this does reduce interest paid.
D. If the loan is paid back in installments, the process becomes more complicated because on average the
borrower had only half the loan for the full year, so r = $1,000/$5,000 = 20 percent on an annual basis.
E. Another fact that influences the effective interest rate is whether or not it is compounded. If it is, then interest
is added on to the deposit as it is earned and the new amount earns interest. Compound interest on deposits is
effectively more than simple interest. The more often it is compounded, the more the effective rate will be.
F. “Let the buyer beware” is a fitting motto in the world of credit.
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