Microeconomic Foundations of the
Economic Theory of Innovation:
Competition and Innovation
B. Verspagen, 2005
The Economics of Technological
Change
Chapter 4
1
Introduction
• Schumpeterian hypotheses: the relationship
between market structure and R&D intensity
• Innovation and R&D are mainly taking place in
large monopolized firms
• R&D intensity is higher for large firms and for
firms with a high degree of monopoly power
– Demand pull perspective: large firms tend to supply to
a larger part of the market and posses superior
knowledge about buyers’ preferences
– Technology push perspective: large firms have more
means to finance R&D from internal sources and
employ more scientists and engineers (importance on
basic R&D)
2
Introduction
• Why Schumpeterian hypotheses are of interest?
• Different implications for static and dynamic efficiency of
an economy
• Static efficiency: fixed technology
– Monopoly may lead to welfare losses due to high prices charged
– Static welfare loss by the loss of the consumer surplus: these
losses are minimized under a fully competitive market structure
• Dynamic efficiency: endogenously generated
technologies within the economy
– An innovation will result in more consumer surplus if it leads to
lower prices or higher product quality: welfare gains from
innovation
3
Incentives to innovate
• Profits are the prime motivation for a firm to innovate
• How much profits a firm can expect from an innovation
partly depends on its market position
• Consider a process innovation that lowers the marginal
production costs
• For monopoly: find the amount a firm would be willing to
pay for license of the patent on the innovation
– Demand evaluated at monopolist’s optimal price
• For competitive market: by buying the license, the firm
will become a monopolist in the market and whether or
not it will charge the monopoly price depends on whether
the innovation is drastic or minor
– Demand evaluated at the pre-innovation marginal production
costs
4
Incentives to innovate
• Competitive market
– For minor innovation, the extra profits from the innovation for a
competitive firm are larger than those for a monopolist
– For drastic innovation, a monopolist and a competitive firm will
earn identical profits after innovation, because the competitive
firm becomes a de facto monopolist after adopting the innovation
• The incentive of competitive firm to introduce the
innovation is larger than the incentive of a monopolist
– Kenneth Arrow: the replacement effect
• A competitive firm has nothing to loose and hence only
to gain from introducing an innovation, while a
monopolist is replacing herself and hence has current
profits to loose
5
Incentives and R&D spending:
patent races
• The role of incentives in the relationship between market
structure and R&D expenditures
• A number of firms is simultaneously trying to develop the
same innovation
• By raising its R&D expenditure, a firm may increase its
chance of making the innovation sooner
• Only the firm that makes the invention first will receive
the patent
• Two different models relating to differences in market
structure
– Threatened monopoly: existing monopolies controls the industry
and the monopolist races with one firm that is currently not
operating in the industry
– Symmetric: there are n firms, neither of which holds a more
advantageous position than any of the others
6
Incentives and R&D spending:
patent races
Threatened monopoly
• Spending more on R&D increases the probability of being first
• Patent race between a monopolist in an industry and an outside firm
• The replacement effect states that a monopolist will have less
incentive to innovate than a potential entrant, because the
monopolist is replacing herself
• The efficiency effect states that a monopolist can always earn at
least as much profits as two duopolists together would be able to
earn
– In the case of minor innovation, the monopolist will also stay in
the market and a duopoly results
– In case of drastic innovation, a monopolist will invest less in R&D
than a potential entrant
– In case of minor innovation, the monopolist may have a higher
incentive to innovate and hence spend more on R&D
7
Incentives and R&D spending:
patent races
Symmetric patent races
• All firms are equal and they are all potential
entrants in an industry
• When the number of firms in the industry
increases, R&D spending per firm goes up, until
the point is reached where R&D is no longer
profitable
• Compared to a single monopolist, any number of
decentralized firms together will spend more on
R&D due to rivalry and duplication in R&D
process
8
Patent races as a common pool
problem
• An individual firm has a clear incentive to innovate for
investing more R&D as the number of rivals goes up
• This will raise the probability of winning the race
compared to the situation of not increasing R&D
spending
• From aggregate point of view, increased spending
shortens the expected innovation date and this raises
the total pay-off of the innovation because it reduces the
negative impact of discounting
• The increased spending that occurs as a reaction of an
increased number of participants is wasteful
• “Common pool problem”
– Entry of an additional firm in the patent race lowers the
probability of all firms to win the race and it also drives up the
costs
9
Technological regimes:
Schumpeter revisited
• Rationality and availability of information on the part of
firms making investments in R&D
– Know exactly the relationship between their R&D investment and
the (expected) cost reductions resulting from innovation
– Know the actions of their competitors, and to include this in their
own decisions
• The only uncertainty is the relationship between R&D
expenditures and innovative success (weak uncertainty)
• If not rely on the assumption of weak uncertainty?
(strong uncertainty)
• Nelson and Winter (1982) model presenting how market
structure and R&D intensity co-evolve under different
technological regimes
10
Technological regimes:
Schumpeter revisited
• Technological regime relates to the possible
sources of knowledge that a firm may use to
develop an innovation
• Internal and external sources:
– Internal: R&D departments, production and marketing
departments as well
– External: competitors (imitated), firms in other
business lines but with related technologies, public
and semi-public institutes (universities)
• Technological regime as the set of conditions
that determine how important these different
sources of knowledge are relative to each other
11
Technological regimes:
Schumpeter revisited
• Schumpeter Mark I regime: Entrepreneurial regime
• The entrants into an industry hold a relatively
favorable position relative to incumbent firms
• Schumpeter Mark II regime: Routinized regime
• Large established firms are the main source of
innovation (incumbent firms have a relative
advantage over outsiders with regard to developing
innovations)
• Nelson and Winter model asks how market structure
and R&D intensity co-evolve under these two
regimes
12
Technological regimes:
Schumpeter revisited
The Model
• Firms sell a homogenous product and capital is the only
production factor
• Process innovations make capital more productive
• Production costs depend on a fixed rate of variable costs
• Firms perform two distinct kinds of R&D:
– Innovative R&D which yields new production
techniques
– Imitative R&D which is aimed at copying techniques
already in use by other firms
• A higher ratio of R&D expenditures per unit of capital
yields a higher probability for innovation or imitation
13
Technological regimes:
Schumpeter revisited
• Firms chose an R&D policy defined as the ratio of R&D
expenditures to capital in use
• Increasing this ratio raises the probability of finding a new
production technique but also decreases current profits
(because R&D expenditures are deducted from gross profits)
• Firms are assumed to act under bounded rationality: satisfiers
• The firm’s policy is adjusted to the industry’s average policy
• Firms produce according to their full production capacity
(determined by capital stock and technology level) and sell all
products in the same period as they are produced
• The market price is determined according to a demand
function that is constant over time
14
Technological regimes:
Schumpeter revisited
• Firms make investment plans by taking into account a desired
markup rate which maximizes their profits under the
assumption that other firms’ output remain constant
• This desired markup depends positively on the market share
of the firm
• More profitable firms are able to invest more than less
profitable firms
• Entry of new firms and exit of existing firms are endogenous
processes
• Exit occurs if a firm falls below a certain threshold size (of the
capital stock) or if a firm’s performance (profits) falls below a
threshold
• Entry is assumed to depend on technological opportunities
(external R&D)
15
Technological regimes:
Schumpeter revisited
• The entrepreneurial and routinized regimes differ
in two respects
• First difference: The efficiency of innovative R&D
differs
• The entrepreneurial regime will yield a lower
probability for innovation
• The probability of innovative entry would be
lower under the entrepreneurial regime
• A higher amount of external R&D under the
entrepreneurial regime
16
Technological regimes:
Schumpeter revisited
• Second difference: Productivity levels
corresponding to innovations
• Under the entrepreneurial regime, innovation
draws are made from a random distribution with
steadily growing mean (called latent productivity)
• Entrants draw their innovations from the same
distribution as incumbent firms
• The routinized regime uses a similar distribution,
but the mean of the distribution is equal to the
average of the firm’s current productivity and
latent productivity
17
Technological regimes:
Schumpeter revisited
• Under the routinized regime, the distribution’s
mean for entrants’ innovative draws is equal to
the average of latent productivity and a base
level productivity parameter that remains
constant over time
• Under the routinized regime, innovation depends
not only on external science but also on firm’s
own experience
• Entry by innovation (new production techniques)
will become much more difficult when the
industry grows older in this regime
18
Technological regimes:
Schumpeter revisited
• The rates of (innovative) entry will differ
between the routinized and
entrepreneurial regimes
• Differences between two regimes in terms
of entry and market structure due to
assumptions
• However, R&D intensity or profit rate are
completely endogenous
• Simulation technique
19
Technological regimes:
Schumpeter revisited
(1) Qit  Ait K it
(2a) Qt   Qit   Ait K it
(2b) Pt  D(Qt )
(3)  it  ( Pt Ait  c  rim  rin )
(4) Pr(dimt  1)  aim rim K it
(5) Pr(dint  1)  ain rin K it
(6) Ai (t 1)  max( Ait , Aˆt , Ait )
(7) K i (t 1)
 Pt Ai (t 1) Qit

I
, ,  it ,   .K it  (1   ) K it
Qt
 c

20
Technological regimes:
Schumpeter revisited
• Under the routinized regime, both the number of
imitations and innovations is higher than under the
entrepreneurial regime
• Under the entrepreneurial regime, the number of
innovations stagnates relative to the number of
imitations, whereas under the routinized regime, these
two variables grow more or less along the same path
• Under both regimes, entry stagnates in the long run, but
under the entrepreneurial regime, imitative entry is
clearly higher than innovative entry
• For the routinized regime, the levels of both types of
entry are more or less the same
21
Technological regimes:
Schumpeter revisited
• Measures of market structure: the number of firms, the
Herfindahl N and C4 measure
• The Herfindahl N indicator is defined as the inverse of the
sum of squared market shares of all firms
– This indicator is high when the market is competitive
(many relatively small firms) and low when the market is
concentrated (monopolistic)
• The C4 indicator is defined as the sum of the market share of
the four largest firms
– This indicator is high for monopolistic markets
• After an initial phase of adjustment, the market structure
indicators for the entrepreneurial regime do not show a clear
trend, but fluctuate around a more or less stable level
• In the routinized regime, there is a clear tendency for the
market to become more monopolized over time
22
Technological regimes:
Schumpeter revisited
The results for batch runs
• The routinized regime shows significantly more
monopolistic market structure towards the second half of
the simulation period, but the reverse is true for the
period just after the initialization
• Average age of firms is higher for the routinized regime
• The profit rate is higher for the entrepreneurial regime
initially but later it is higher for the routinized regime
• Total R&D expenditures are higher under the routinized
regime, but this is the result of higher innovative R&D
expenditures
• Imitative R&D expenditures are lower for the routinized
regime
23
Technological regimes:
Schumpeter revisited
• These results confirm the Schumpeterian hypotheses:
R&D intensity is higher in industries that are monopolistic
• This finding is not the result of a one-way causal
interaction from market structure to R&D expenditures as
in the simple Schumpeterian literature
• Market structure and R&D intensity co-evolve under the
influence of exogenous differences in the knowledge
base
• While innovative R&D is higher for market structures that
are relatively monopolistic, the reverse holds for imitative
R&D
24
Conclusions
• The investigation of the relationship between market
structure and R&D expenditures
• Schumpeterian hypotheses that large firms with a high
degree of monopoly power tend to spend more on R&D
than small firms that operate on a competitive basis
• The patent race models tend to stress the role of
incentives on the decision on how much to invest in
R&D:
– A patent race between an incumbent monopolist and a
challenging potential entrant
– A patent race between a number n of equal rivals
• The evolutionary model dealing with the issue of
technology regimes co-evolving
25
Conclusions
The patent race models:
• First case: the impact of monopoly power on R&D
expenditures depends on the size of the expected
innovation
• In case of drastic innovations, the potential entrant will
spend more on R&D than the incumbent monopolist,
while the reverse is true for minor innovations
• In the case of drastic innovations, the losses for the
monopolist due to the replacement effect are relatively
large
• The impact of monopoly power on R&D expenditures
depends on factors such as the size of the innovation
26
Conclusions
The patent race models:
• Second case: a symmetric race is analyzed and it
underlies the possibility that due to competition between
firms, R&D expenditures of each individual firm may rise
• This goes against the Schumpeterian hypothesis of a
positive relation between size and monopoly power and
R&D expenditures
• The spiral higher R&D expenditures due to stronger
competition must break down at the point where the
higher R&D costs reduce overall profitability
• Competition again has a negative effect on R&D
spending ( a non-monotonic relationship)
27
Conclusions
The evolutionary model
• Dealing with the issue of technology regimes
• Differences in the knowledge base underlying different
industries may lead to both differences in market structure
and R&D spending
• Whether or not monopolistic market structure tend to go with
higher R&D expenditures depends on whether one considers
innovative R&D or imitative R&D
• The imitative R&D tends to be higher in competitive markets,
the innovative R&D in monopolistic markets
• This conclusion that the relationship between market structure
and R&D expenditures may differ with the type of innovations
is in accordance with the result from the asymmetric patent
race model
28
Conclusions
• No obvious relation between market
structure and innovation
• The causality of this relationship goes both
ways: market structure determines R&D
expenditures and vice versa
• Which combinations of market structure
and R&D intensity will result depends on
the size of the innovations or the
characteristics of the knowledge base
29