IO Chapter 16

We have been alluding throughout, to the possibility that perfect competition may not be the ideal market structure for encouraging R and D. This chapter provides a more concrete discussion of that issue.

We need to ask two questions:

1. Who is likely to benefit from R and D?

2. Who can afford to invest in R and D?

A simple model on p. 293 (figure 16.1) suggests that the biggest beneficiaries would be those in a pc world.

This is because the gains from lowering costs are greater for a pc firm. Monopolists have a disincentive because they are already earning profits.

But why then is it the case that we don't see as much investment in a perfectly competitive world? In fact the evidence suggests that large, more oligopolistic firms carry out most R and D.

So why might this not work as the simple model shows?

1. credit markets are imperfect

Large firms with market power have more cash available to invest in R and D.

2. By definition, a firm that innovates is creating a monopolistic situation for themselves, since their cost structure will be different than everyone else's. (And yet there will be no incentive to do this, if all the other firms can instantly copy one's innovation.)

Schumpeter observed two things:

1. Firms that do most R and D are NOT competitive firms.

2. The very process of innovation leads to market power.

He concluded that 'creative destruction' and dynamic competition were necessary, rather than a static perfectly competitive model that is taught in most economics classes. In this case, firms are constantly trying to innovate in order to capture some monopoly rents, but as long as other firms are also innovating, there is always the threat of competition and even becoming obsolete which keeps firms doing R and D and innovating.

This is a somewhat ideal notion. Consider again the example of Microsoft. If a company is so big that it can simply buy out and the squash any innovations which would advance technology and possibly make its product obsolete, then the model is not working very well...)

A related question one must ask is: does this process lead to the persistence of monopoly power?

In some cases yes, in others no.

In the case of a small innovation in a product (gradual innovation), the monopolist has the incentive to do this, or to buy out a R and D firm doing it, rather than letting a rival get a hold of the product, since this would lead to a duopoly and thus a reduction in the firm's profits and market power.

In the case of major or drastic innovations, or in the case of uncertainty, the monopolist may have less incentive to invest and so a rival may develop a new product which makes the monopolist obsolete at some point.

R and D is also complicated by the question, where should the money be spent? There are often multiple ways in which a product can be improved. This also leads to the same conclusion as before.

Existing firms are more likely to be cautious in the types of R and D they do. (Gradual innovation). New firms have more to gain, and less to lose, so they may go for drastic innovations.

So there is some evidence that R and D can help maintain monopoly power, while there is also evidence that major innovations may topple monopoly power.

Another way in which dominant firms have an advantage is in the actual production process, as this may lead to innovation in itself.

There may also be a differences in how effective firms are in terms of innovating.

So what policies should be enacted to help R and D?

1. Patents and copyrights.

There are a number of issues policy makers need to decide on.

a. How is an innovation defined?

b. How long should a patent be?

c. How strong/extensive should the patent be?

The first thing that must be determined is whether an innovation is in fact new. There is a lot of contraversy around this issue at present. For example seed companies are trying to patent rice which they claim they invented but which indigenous peoples may have been using for centuries. In other words the question of property rights is very contraversial and there are a number of large international firms trying to exploit these issues.

On the issue of the length of time for which a patent is granted, policy makerss need to keep in mind that there is a trade off between dynamic and allocative efficiency. Since patents are government created monopoly power, they have an allocative efficiency cost, but the benefit is a dynamic efficiency gain. (Again, this is being called into question in the case of rice patents, where much of the 'research' was done by indigenous farmers, but suddenly these seed companies are trying to claim them. By the way, they are also forcing US farmers to sign agreements that they will not produce their own seed, but instead that they will continue buying seed from the seed companies. This is the ugly side of copyright issues... Also, as we discussed in class, there is a fine line between creating a 'healthy' amount of market power, and too much. In other words, a firm with too much protection may no longer innovate.)

In answer to the first question, US has decided on 17 years, while the EU decided on 20.

In terms of the second question, it is more tricky.

How broad should patents be? Ex: tennis racket.

How much access should other firms have to the technology?

One option is to require firms to allow other firms access to their technology, but allow them to charge a fee.

See Figure 16.2.

2. R and D agreements

If the R and D is likely to be a public good and benefit all (thus there is no incentive for one firm to carry out the research) then these agreements may be worthwhile.

Also, in the case of very expensive, very extensive R and D, collaboration may be good.

But think of the duopoly model (each firm produced less at a lower price than the monopolist.)

If two firms join for the purposes of R and D, the total they will spend on R and D will probably be less than the two would spend if separate.

3. Although the book downplays this, the government can also subsidize firms's research, or provide funding to independent research organizations such as universities, to provide R and D.

4. Finally the government can do research itself.

In fact most governments carry out all four strategies - they provide limited monopoly power to innovating firms, but they also fund public research. Why are both important?

1. What types of R and D are firms likely to invest in?

Only those which they think they can profit from.

So what will happen to research on for instance public health (reducing the incidence of disease) which firms cannot profit from? They will not invest in this research.

Thus it is naive to assume that the private sector will take care of all R and D needs, even if the incentive structure is correct.