Economics of Innovation & Intellectual Property
H1 Industrial organization: Innovation & Market Structure
1. Introduction
Improve standard of living ability to raise its output per worker
Companies & workers need to keep getting more output from the same number of inputs
Innovation = how productivity growth happens = single largest determinant of growth
Exogenous growth model of Solow
- Output depends on capital (K), labour (L) and technology (A): Cobb-Douglas: 𝑌 = 𝐾 𝛼 (𝐴𝐿)1−𝛼
𝑠 1⁄(1−𝛼)
- Growth rate of capital stabilizes at k* = (𝑛+𝑔+𝛿)
o s = savings rate o n = growth rate of the labor force
o 𝛿 = depreciation rate o g = growth rate of technology = A(t) = A/A
- output per person = y = Y/L = 𝐴 ∗ 𝑘 ∗𝛼
➔ interpretation : welfare increases with technology, where the other drivers of technology are fixed
or subject to diminishing returns
➔ Solow takes 𝑔 as given, later work allows it to be determined by firm R&D
→ Endogenous growth theory (Romer 1990, Aghion & Howitt 1992)
Total Factor Productivity = TFP → determines most growth of labor productivity (empirical research)
- Technology = growth in Total Factor Productivity (TFP), the part of output growth that we cannot explain
by the growth in inputs
➔ A much broader notion of technology than high-tech gadgets: includes all ways of improving
efficiency, including organization, management, training, ...
- 3 parts
o Tools (pots, pans, knives, ovens to prepare a dish)
o Explicit instruction = knowhow (recipes, blueprints, patents that can be written down)
o Process knowledge = tacit knowledge = proficiency gained from practical experience, which
isn’t easily communicated (ask someone who has never cooked to simply cook an egg / give a
beautiful kitchen and detailed recipe and might still make a mess)
➔ Sollow: 87% of labor growth is explained by TFP growth
➔ Later studies: smaller (but stil big) contributions of TFP
economic policy (macro-policy) aim: 2% inflation = 2% economic growth
history (1000 years ago) growth was nearly 0 until 1850’s
However: TFP growth is slowing down, even though we invest more in R&D
Need to reignite the productivity growth: to keep getting wealthier
3% of GDP growth must go to R&D (now only 2%)
1
,Innovation & competition:
- Amazon = leading e-retailer in the US 2023: this level of market concentration is new (digital platforms
lead to higher concentration in the market)
- Diffusion:
o Eg invention of the refrigerator: people don’t think about the possibility of a refrigerator before it
has been invented → it skyrockets very quickly after its has come into existence)
o Isn’t trivial: the Solow Paradox “You can see the computer age everywhere but in the
productivity statistics.”
o IT development takes of in the 70s & 80s productivity effects show up in the later 90s!
▪ Complementary investments needed to be made (networks, software, training,
organisation) → technology needs to be integrated
▪ Significant learning costs and inefficiencies.
▪ Exponential growth still started small initially.
▪ Price indexes undermeasure quality adjusted outputs.
The Innovation Process AGENTS
EXTERNAL-
OR FIRM-LEVEL
MARKET-LEVEL
PROCESS
INITIATIVES FIRM-LEVEL INITIATIVES
Applied research Development Adoption or
Basic research Investment purchase decision
ACTIVITIES Information collation Testing
Inventions Prototypes Market penetration
Discoveries Innovation
OUTPUTS Blueprints Beta-versions
Ideas (product or process)
Plans
Adaptation
Improvement
- Knowledge STAGE
RESEARCH AND DEVELOPMENT COMMERCIALISATION DIFFUSION
o Codified: can be written down 1 2 3 2 4 5
o Tacit: is embodied in individuals, can’t be transferred easily
- Technology
o Production techniques used to design, make, package and deliver goods
o Application of selected parts of knowledge
o Combined with other inputs (energy, capital…) this determines productivity
- Invention
o Idea resulting from a chance or systematic research (something developed)
o Inventions are knowledge
- Innovation
o Turning an invention into an economically viable good (developed + integrated in the market)
o Innovation is a technology that solves a problem
o Cannot happen without invention
- Diffusion
o Process through which innovations become used by others
o Source of societal welfare: reaping gains of better technology
o Reaching individuals and groups external to the innovator
Who invests in innovation?
- The private sector as primary investor
o Intangible assets become more important for competitive success
- The public sector enables and compensates
o Governments provide incentives, build infrastructure, and compensates in areas where firms
underinvest through policy
o Incentives: subsidies, patent systems, …
o Infrastructure: universities, public research centers, …
o Compensates: funding basic research and key technological fields
- Distribution of R&D spending between sectors:
o business enterprise = biggest sector
o who does research =/ who pays for the research → government pays for most of it
2
,2. Innovation and market structure
How to encourage innovation (in order to improve welfare)?
➔ Certain market structures are more encouraging than others
➔ 3 questions:
o How does market structure affect incentives for R&D?
o How can innovation influence market structure?
o How do firms use R&D strategically?
Definitions:
- Product innovation = generation, introduction, and diffusion of a new production process (with the
products unchanged) = new or significantly improved product
- Process innovation = generation, introduction, and diffusion of a new product (with the production
process unchanged) = cost reduction, quality increase…
- Marketing innovation = new marketing methods (design, packaging…)
- Organisational innovation = new business practices for organizing procedures
- Drastic (or major) innovation = post-innovation, the innovator can behave as a monopolist without
being constrained by price competition
- Non-drastic (or minor) innovation = innovator may gain some cost advantage, but competition
constrains the innovator
Simplifying Assumptions
- Goods are homogenous
- Perfect competition, firms compete on price
- Innovation = process innovation
▪ Reduction of MC
▪ Drastic: outcompetes others, innovator becomes monopolist
▪ Non-drastic: innovator still constraint by competitive price
Drastic Process Innovation
- Before innovation
▪ MC = c0
▪ Competitive market: p = c0
▪ Profit: π = qc * (p – c0) = 0
- After innovation
▪ MC lowers to cd << c0
▪ Innovator can set price pm < p
▪ Other firms lose money with price at pm
▪ Innovator becomes monopolist
▪ Profit: πm = qm * (pm – cd)
▪ Recall: price maximisation at Q where MR = MC
Non-drastic Process Innovation
- Before innovation (see above)
- After innovation
▪ MC lowers to cnd < c0
▪ Monopoly price pm still higher than original p
▪ Innovator keeps price at original level p
▪ Innovator becomes monopolist
▪ Profit: πm = qc * (p – cnd)
3
, Reasons for Innovation
- Joseph Schumpeter: first to link innovation and market structure
o Schumpeter mark I:
‘Innovation happens because dominant firms are outcompeted by start-ups with better
ideas. It is about the individual.’
o Schumpeter mark II:
‘Innovation happens because dominant firms have a lot of resources to develop new
inventions, and short-term monopolies guarantee returns. It is about large firms with a lot
of market power.’
▪ The probability that a firm does R&D increases with size.
• Small firms specialize more in research.
• Large firms specialize more in development and will buy a considerable fraction
of the research basis for their development from small firms.
▪ Among firms to do R&D:
• R&D spending is proportional to firm size in most industries.
• R&D productivity – the number of innovations per unit of R&D spending – falls as
firms size increases.
• However: larger firms can still benefit because their average cost for R&D is lower
▪ Advantage of large firm innovation
• Externalities: firm with many products can better exploit innovation
• Indivisibilities: with large fixed investments, large firms have more resources to
exploit economies of scale and scope
• Uncertainty: large firms have more resources to cope with risk
The Arrow Model
- = how much is a firm willing to pay for an innovation that it would be the only one to use?
- Assumptions
o Homogenous product, no differentiation
o Inverse demand of p = 100 – Q
o Constant MC = c0 = 50
o Non-drastic innovation, no uncertainty, MC drops to c1 (= 25) < c0
- Question: what is profit incentive to innovate?
o = additional profit realized by the innovation
o Can be seen as price to buy an innovation
o Compare: monopolist, perfect competitive market and social planner
- Monopolist
o Before innovation
▪ Price p0 = 75 (MC = MR)
▪ Profit π0 = q0 * (p0 – c0) = 625
o After innovation
▪ Price p1 = 62,5 (MC = MR)
▪ Profit π1 = q1 * (p1 – c1) = 1406,25
→ π1 - π0 = 781,25
- Perfect competition
o Before innovation
▪ Price p0 = 50 (= c0)
▪ Profit π0 = q0 * (p0 – c0) = 0
o After innovation
▪ Price p1 = 50 (= c0)
▪ Profit π1 = q1 * (p1 – c1) = 1250
→ π1 - π0 = 1250
4
H1 Industrial organization: Innovation & Market Structure
1. Introduction
Improve standard of living ability to raise its output per worker
Companies & workers need to keep getting more output from the same number of inputs
Innovation = how productivity growth happens = single largest determinant of growth
Exogenous growth model of Solow
- Output depends on capital (K), labour (L) and technology (A): Cobb-Douglas: 𝑌 = 𝐾 𝛼 (𝐴𝐿)1−𝛼
𝑠 1⁄(1−𝛼)
- Growth rate of capital stabilizes at k* = (𝑛+𝑔+𝛿)
o s = savings rate o n = growth rate of the labor force
o 𝛿 = depreciation rate o g = growth rate of technology = A(t) = A/A
- output per person = y = Y/L = 𝐴 ∗ 𝑘 ∗𝛼
➔ interpretation : welfare increases with technology, where the other drivers of technology are fixed
or subject to diminishing returns
➔ Solow takes 𝑔 as given, later work allows it to be determined by firm R&D
→ Endogenous growth theory (Romer 1990, Aghion & Howitt 1992)
Total Factor Productivity = TFP → determines most growth of labor productivity (empirical research)
- Technology = growth in Total Factor Productivity (TFP), the part of output growth that we cannot explain
by the growth in inputs
➔ A much broader notion of technology than high-tech gadgets: includes all ways of improving
efficiency, including organization, management, training, ...
- 3 parts
o Tools (pots, pans, knives, ovens to prepare a dish)
o Explicit instruction = knowhow (recipes, blueprints, patents that can be written down)
o Process knowledge = tacit knowledge = proficiency gained from practical experience, which
isn’t easily communicated (ask someone who has never cooked to simply cook an egg / give a
beautiful kitchen and detailed recipe and might still make a mess)
➔ Sollow: 87% of labor growth is explained by TFP growth
➔ Later studies: smaller (but stil big) contributions of TFP
economic policy (macro-policy) aim: 2% inflation = 2% economic growth
history (1000 years ago) growth was nearly 0 until 1850’s
However: TFP growth is slowing down, even though we invest more in R&D
Need to reignite the productivity growth: to keep getting wealthier
3% of GDP growth must go to R&D (now only 2%)
1
,Innovation & competition:
- Amazon = leading e-retailer in the US 2023: this level of market concentration is new (digital platforms
lead to higher concentration in the market)
- Diffusion:
o Eg invention of the refrigerator: people don’t think about the possibility of a refrigerator before it
has been invented → it skyrockets very quickly after its has come into existence)
o Isn’t trivial: the Solow Paradox “You can see the computer age everywhere but in the
productivity statistics.”
o IT development takes of in the 70s & 80s productivity effects show up in the later 90s!
▪ Complementary investments needed to be made (networks, software, training,
organisation) → technology needs to be integrated
▪ Significant learning costs and inefficiencies.
▪ Exponential growth still started small initially.
▪ Price indexes undermeasure quality adjusted outputs.
The Innovation Process AGENTS
EXTERNAL-
OR FIRM-LEVEL
MARKET-LEVEL
PROCESS
INITIATIVES FIRM-LEVEL INITIATIVES
Applied research Development Adoption or
Basic research Investment purchase decision
ACTIVITIES Information collation Testing
Inventions Prototypes Market penetration
Discoveries Innovation
OUTPUTS Blueprints Beta-versions
Ideas (product or process)
Plans
Adaptation
Improvement
- Knowledge STAGE
RESEARCH AND DEVELOPMENT COMMERCIALISATION DIFFUSION
o Codified: can be written down 1 2 3 2 4 5
o Tacit: is embodied in individuals, can’t be transferred easily
- Technology
o Production techniques used to design, make, package and deliver goods
o Application of selected parts of knowledge
o Combined with other inputs (energy, capital…) this determines productivity
- Invention
o Idea resulting from a chance or systematic research (something developed)
o Inventions are knowledge
- Innovation
o Turning an invention into an economically viable good (developed + integrated in the market)
o Innovation is a technology that solves a problem
o Cannot happen without invention
- Diffusion
o Process through which innovations become used by others
o Source of societal welfare: reaping gains of better technology
o Reaching individuals and groups external to the innovator
Who invests in innovation?
- The private sector as primary investor
o Intangible assets become more important for competitive success
- The public sector enables and compensates
o Governments provide incentives, build infrastructure, and compensates in areas where firms
underinvest through policy
o Incentives: subsidies, patent systems, …
o Infrastructure: universities, public research centers, …
o Compensates: funding basic research and key technological fields
- Distribution of R&D spending between sectors:
o business enterprise = biggest sector
o who does research =/ who pays for the research → government pays for most of it
2
,2. Innovation and market structure
How to encourage innovation (in order to improve welfare)?
➔ Certain market structures are more encouraging than others
➔ 3 questions:
o How does market structure affect incentives for R&D?
o How can innovation influence market structure?
o How do firms use R&D strategically?
Definitions:
- Product innovation = generation, introduction, and diffusion of a new production process (with the
products unchanged) = new or significantly improved product
- Process innovation = generation, introduction, and diffusion of a new product (with the production
process unchanged) = cost reduction, quality increase…
- Marketing innovation = new marketing methods (design, packaging…)
- Organisational innovation = new business practices for organizing procedures
- Drastic (or major) innovation = post-innovation, the innovator can behave as a monopolist without
being constrained by price competition
- Non-drastic (or minor) innovation = innovator may gain some cost advantage, but competition
constrains the innovator
Simplifying Assumptions
- Goods are homogenous
- Perfect competition, firms compete on price
- Innovation = process innovation
▪ Reduction of MC
▪ Drastic: outcompetes others, innovator becomes monopolist
▪ Non-drastic: innovator still constraint by competitive price
Drastic Process Innovation
- Before innovation
▪ MC = c0
▪ Competitive market: p = c0
▪ Profit: π = qc * (p – c0) = 0
- After innovation
▪ MC lowers to cd << c0
▪ Innovator can set price pm < p
▪ Other firms lose money with price at pm
▪ Innovator becomes monopolist
▪ Profit: πm = qm * (pm – cd)
▪ Recall: price maximisation at Q where MR = MC
Non-drastic Process Innovation
- Before innovation (see above)
- After innovation
▪ MC lowers to cnd < c0
▪ Monopoly price pm still higher than original p
▪ Innovator keeps price at original level p
▪ Innovator becomes monopolist
▪ Profit: πm = qc * (p – cnd)
3
, Reasons for Innovation
- Joseph Schumpeter: first to link innovation and market structure
o Schumpeter mark I:
‘Innovation happens because dominant firms are outcompeted by start-ups with better
ideas. It is about the individual.’
o Schumpeter mark II:
‘Innovation happens because dominant firms have a lot of resources to develop new
inventions, and short-term monopolies guarantee returns. It is about large firms with a lot
of market power.’
▪ The probability that a firm does R&D increases with size.
• Small firms specialize more in research.
• Large firms specialize more in development and will buy a considerable fraction
of the research basis for their development from small firms.
▪ Among firms to do R&D:
• R&D spending is proportional to firm size in most industries.
• R&D productivity – the number of innovations per unit of R&D spending – falls as
firms size increases.
• However: larger firms can still benefit because their average cost for R&D is lower
▪ Advantage of large firm innovation
• Externalities: firm with many products can better exploit innovation
• Indivisibilities: with large fixed investments, large firms have more resources to
exploit economies of scale and scope
• Uncertainty: large firms have more resources to cope with risk
The Arrow Model
- = how much is a firm willing to pay for an innovation that it would be the only one to use?
- Assumptions
o Homogenous product, no differentiation
o Inverse demand of p = 100 – Q
o Constant MC = c0 = 50
o Non-drastic innovation, no uncertainty, MC drops to c1 (= 25) < c0
- Question: what is profit incentive to innovate?
o = additional profit realized by the innovation
o Can be seen as price to buy an innovation
o Compare: monopolist, perfect competitive market and social planner
- Monopolist
o Before innovation
▪ Price p0 = 75 (MC = MR)
▪ Profit π0 = q0 * (p0 – c0) = 625
o After innovation
▪ Price p1 = 62,5 (MC = MR)
▪ Profit π1 = q1 * (p1 – c1) = 1406,25
→ π1 - π0 = 781,25
- Perfect competition
o Before innovation
▪ Price p0 = 50 (= c0)
▪ Profit π0 = q0 * (p0 – c0) = 0
o After innovation
▪ Price p1 = 50 (= c0)
▪ Profit π1 = q1 * (p1 – c1) = 1250
→ π1 - π0 = 1250
4
