Introduction
Theoretical arguments
Empirical evidence
The Economics of Science and Innovation
Market Structure and Incentives to Innovate
Lecture 4
Natalia Zinovyeva
Aalto University
[email protected]
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Introduction
Theoretical arguments
Empirical evidence
Outline
1
Introduction
2
Theoretical arguments
Dealing with market failures (Schumpeter)
Price competition (Arrow)
Quantity competition (Belleflamme and Vergari)
Deterring entry (Gilbert and Newberry)
3
Empirical evidence
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Introduction
Theoretical arguments
Empirical evidence
Motivation
IPR protection is meant to balance dynamic efficiency (moving from no
innovation to innovation) and static efficiency (post-innovation)
Which market structure (pre-innovation) is most conducive to innovation?
Should we worry about the innovation and development in highly concentrated
markets and in too large firms – Microsoft, Kodak, AT&T, Google?
What are the policy implications?
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Introduction
Theoretical arguments
Empirical evidence
Number of patents by firm size (UK) (Rogers et al. 2007)
Size based on total assets: Large>£28.7M, SME>£1.3M, Micro<£1.3M
⇒ Large firm category is overtaken by the combined set of SMEs and micro firms in
terms of total number of patents
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Introduction
Theoretical arguments
Empirical evidence
Number of firms that patent, by firm size (UK) (Rogers et
al. 2007)
⇒ In proportion to their asset base, SMEs and micro firms are more IP intensive than
large firms
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Introduction
Theoretical arguments
Empirical evidence
Outline
1
Introduction
2
Theoretical arguments
Dealing with market failures (Schumpeter)
Price competition (Arrow)
Quantity competition (Belleflamme and Vergari)
Deterring entry (Gilbert and Newberry)
3
Empirical evidence
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Introduction
Theoretical arguments
Empirical evidence
Schumpeter 1942
The atomistic firm in a competitive market
is the suitable vehicle for static resource
allocation, but the large firm operating in
a concentrated market is the most
powerful engine of progress and [. . . ]
long run expansion of output [. . . ] perfect
competition [. . . ] has no title to being set
up as a model of ideal efficiency.
Schumpeter (1942)
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Introduction
Theoretical arguments
Empirical evidence
Schumpeter (1942): Two hypotheses
1
2
Innovation increases more than proportionately with firm size
I
Large firms deal better with market failures (assumptions: firms exploit
innovations through their own output and current firm size limits firm
growth)
I
Economies of scale and scope
I
Large diversified firms are in better position to exploit unforeseen
innovations
I
Large companies spread risk involved in R&D by undertaking many
projects at the same time
I
Better access to finance
Innovation increases with market concentration
I
Firms with greater market power are rather able to finance R&D through
own profits
I
Firms with market power can more easily appropriate the returns from
innovation and therefore have better incentives to innovate
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Introduction
Theoretical arguments
Empirical evidence
Arrow (1962): Incentives to innovate and market structure
How much is a firm willing to pay for an innovation that it would be the only
one to use (perfect appropriability)?
Comparison between:
I
Competitive market (Bertrand competition)
I
Monopoly
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Introduction
Theoretical arguments
Empirical evidence
70 80
120
Competitive market with patents. Firm incentives to
innovate.
$/Unit
MC0
20
q=120-p
MC1
0
MR
0
40
50
120
Quantity
Since before innovation the firm operated in a competitive market with zero profits,
its incentive to innovate is equal to π m (c1 ).
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Introduction
Theoretical arguments
Empirical evidence
70 80
120
Competitive market with patents. Firm incentives to
innovate and social optimum.
$/Unit
MC0
20
q=120-p
MC1
0
MR
0
40
50
120
Quantity
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Introduction
Theoretical arguments
Empirical evidence
70 80
100
Monopoly incentives to innovate.
$/Unit
MC0
20
q=120-p
MC1
0
MR
0
20
50
120
Quantity
If before innovation firm operated as a monopoly, monopolist incentive to innovate is
equal to the difference between current and expected profits: π m (c1 ) − π m (c0 ).
Monopolist experiences a replacement effect: the firm loses its stream of profits by
innovating, i.e. it has to replace its own profits.
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Introduction
Theoretical arguments
Empirical evidence
Price competition:
In a setting when only one firm can innovate, and the inventing firm is granted
exclusive property rights on the new technology:
I
Both the competitive firm and the monopolist undervalue the innovation
relative to the social planner
I
Incentive is greater when competition exists previous to innovation than
under monopoly.
[W]hat’s the point of focusing on making the product even better when the only
company you can take business from is yourself? Steve Jobs (2004)
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Introduction
Theoretical arguments
Empirical evidence
Innovation in oligopoly
Belleflamme and Vergari (2011)
Cournot competition, homogenous product
Drastic innovation
I
Incentives to innovate of the monopolist: π m (c1 ) − π m (c0 )
I
Incentives to innovate of the duopolist: π m (c1 ) − π d (c0 , c0 )
I
⇒ Since replacement effect is smaller in a less concentrated market,
incentives to innovate increase with competition.
Non-drastic innovation
I
Incentives to innovate of the monopolist: π m (c1 ) − π m (c0 )
I
Incentives to innovate of the duopolist: π d (c1 , c0 ) − π d (c0 , c0 )
I
⇒ Replacement effect is smaller, but also possible profits are smaller.
I
It turns out that for small innovations, monopoly has the largest incentive
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Introduction
Theoretical arguments
Empirical evidence
Competition between incumbent monopolist and entrant
Gilbert and Newberry (1982)
Cournot competition between incumbent monopolist using an old technology
and a potential entrant for an innovation.
Payoffs:
I If the incumbent gets the innovation, then entrant stays out.
I
F
Incumbent’s profit: π m (c1 )
F
Entrant’s profit: 0
If entrants gets the innovation, then entrant enters.
F
Incumbent’s profit: π d (c0 , c1 )
F
Entrant’s profit: π d (c1 , c0 )
Incentives to innovate
I
Incumbent: π m (c1 ) − π d (c0 , c1 ), the difference of its monopoly profits
with technology c1 and its profits if its rival wins the bidding.
I
Entrant: π d (c1 , c0 ), the duopoly profit when the firm has cost c1 and the
rival c0 .
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Introduction
Theoretical arguments
Empirical evidence
Competition between incumbent monopolist and entrant
Gilbert and Newberry (1982)
The monopolist has weakly stronger incentives to invest:
π m (c1 ) − π d (c0 , c1 ) ≥ π d (c1 , c0 )
This follows since the monopoly profit with marginal cost c1 is at least as large
as the sum of the duopoly profits.
This effect occurs due to the efficiency effect, i.e., the monopolist wants to
preempt entry. Replacing oneself is better than being replaced by a newcomer.
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Introduction
Theoretical arguments
Empirical evidence
Patent races: time and uncertainty
Fudenberg, Gilbert, Stiglitz, Tirole (1983)
Suppose that firms decide both on the intensity of R&D and the timing of R&D
investment. The objective is to be the first to come up with an innovation.
Combined influence of:
I
Replacement effect: monopoly power
I
Efficiency effect: threat of entry
In a patent race, it is in general ambiguous whether the incumbent or the entrant
has a stronger incentive to invest.
I
Net flow profit incumbent receives by preempting the entrant is larger than
what the entrant gains by being first.
I
By investing more, incumbent hastens its own replacement (has less time
to exploit its own monopoly power of existent technology)
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Introduction
Theoretical arguments
Empirical evidence
To sum up:
Theory provides many arguments in favor of both competition and more
concentrated markets.
A particular prescription seems to depend on:
I
The type of competition (price or quantity)
I
The type of technological innovation: drastic/non-drastic, speed of
progress, product/process
I
Barriers to entry
I
Information asymmetries, uncertainty, appropriability
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Introduction
Theoretical arguments
Empirical evidence
Outline
1
Introduction
2
Theoretical arguments
Dealing with market failures (Schumpeter)
Price competition (Arrow)
Quantity competition (Belleflamme and Vergari)
Deterring entry (Gilbert and Newberry)
3
Empirical evidence
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Introduction
Theoretical arguments
Empirical evidence
Innovation increases with firm size
Testing Schumpeter’s first hypothesis
Regress some measure of innovative output or input on a measure of size
Summary of findings (Cohen, 1995; Gilbert, 2006):
I
Likelihood of undertaking R&D is greater the larger is the firm
I
Number of innovations tends to increase less than proportionately with
firm size
I
⇒ R&D productivity declines with firm size
Crucial assumptions:
I
Causality runs from firm size to innovation
I
No omitted variables, correlated with firm size and innovation (capital
intensity, sector of activity, etc.)
I
No endogenous atrition
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Introduction
Theoretical arguments
Empirical evidence
Innovation increases with concentration
Testing Schumpeter’s second hypothesis
Regress a measure of innovative activity on a measure of concentration
Early findings :
I
Negative / positive relationship between concentration and innovation
(Schumpeter 1943; Nickell 1996; Blundell, Griffith, and Van Reenen
1999)
I
Non-linear inverted-U shaped relationship (Scherer 1967) General
conclusion: Conditioning on firm size, effect of concentration on
innovation relatively weak - rather result of other industry characteristics
Crucial assumptions: see above.
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Introduction
Theoretical arguments
Empirical evidence
Inverted-U shaped relationship
Aghion, Bloom, Blundell, Griffith, and Howitt, (2005 QJE)
Aghion et al. provide evidence from the UK firms consistent with an inverted
U-shaped relationship between competition and innovation.
Data
I
All accounting information from stock market listed firms in 17 industries
in 1973-1994.
I
Patents and their citations for a sample of firms.
The unit of analysis: industry-year (354 observations)
Variables
I
Innovation measure (p): The number of patents weighted by the number of
citations that they received in the future.
I
Competition measure (c): industry average price-cost margin (the Lerner
index), operating profit minus financial costs divided by sales. Advantage
over market share of Herfindahl concentration – does not need to rely on a
definition of geographic and product markets.
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Introduction
Theoretical arguments
Empirical evidence
Innovation and competition
Aghion, Bloom, Blundell, Griffith, and Howitt, (2005 QJE)
706
QUARTERLY JOURNAL OF ECONOMICS
Downloaded from http://qje.oxfordjournals.org/ at Aalto University Li
FIGURE I
Scatter Plot of Innovation on Competition
The figure plots a measure of competition on the x-axis against citationweighted patents on the y-axis. Each point represents an industry-year. The
scatter shows all data points that lie in between the tenth and ninetieth deciles in
the citation-weighted patents distribution. The exponential quadratic curve that
is overlaid is reported in column (2) of Table I.
Note: A value of 1 of competition index indicates perfect competition while values below 1 indicate some degree of market power.
dustry patent behavior is related to industry competition according to
(4)
E! p jt!c jt, x jt" ! e # g$cjt%&x'jt(),
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Introduction
Theoretical arguments
Empirical evidence
The empirical challenges and some solutions
Aghion, Bloom, Blundell, Griffith, and Howitt, (2005 QJE)
Estimate how the expected number of patents (p) is affected by competition c
Problems (as in the previous literature):
I
Inverse causality
I
Omitted variable bias (unobservable factors relevant for patenting and
correlated with competition)
Solutions:
I
Time-invariant unobserved heterogeneity ⇒ industry fixed effects
I
Time effect ⇒ year dummy variables
Policy instruments as a source of exogenous variation in industrywide
competition:
I
F
Thatcher era privatizations
F
EU Single Market Programme and related trade liberalization in some
sectors
F
Competition regulation by Monopoly and Merge Commission
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Introduction
Theoretical arguments
Empirical evidence
Innovation and competition
708 Griffith,QUARTERLY
JOURNAL
OF QJE)
ECONOMICS
Aghion, Bloom, Blundell,
and Howitt,
(2005
TABLE I
EXPONENTIAL QUADRATIC: BASIC SPECIFICATION
(1)
(2)
Data frequency
Annual
152.80
(55.74)
!80.99
(29.61)
Competitionjt
Competition squaredjt
Significance of: Competitionjt ,
Competition squaredjt
Significance of policy instruments
in reduced form
Significance of other instruments
in reduced form
Control functions in regression
R 2 of reduced form
Year effects
Industry effects
Observations
Annual
(3)
5-year
averages
Annual
387.46
(67.74)
!204.55
(36.17)
819.44
(265.63)
!434.43
(141.43)
385.13
(67.56)
!204.83
(36.06)
7.60
(0.02)
38.34
(0.00)
9.97
(0.01)
Yes
Yes
Yes
354
Yes
Yes
67
32.59
(0.00)
10.11
(0.002)
5.00
(0.000)
4.38
(4.04)
0.801
Yes
Yes
354
354
(4)
Competitionjt is measured by (1-Lerner index) in the industry-year. All columns are estimated using an
unbalanced panel of seventeen industries over the period 1973 to 1994. Estimates are from a Poisson
regression. Numbers in brackets are standard errors. The standard errors in column (4) have not been
corrected for the inclusion of the control function. Significance tests show likelihood ratio test-statistics and
P-value from the F-test of joint significance. The fourth column includes a control function. The excluded
variables are policy instruments specified in Table II, imports over value-added in the same industry-year,
TFP in the same industry-year, output minus variable costs over output in the same industry-year and
estimates of markups from industry-country regression [Martins et al. 1996] interacted with time trend, all
for the United States and France.
Downloaded from http://qje.oxfordjournals.org/ at Aalto University Library on F
Dependent variable: citationweighted patents
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Introduction
Theoretical arguments
Empirical evidence
To sum up:
Empirical evidence suggests that there exists an inverted-U shape relationship
between market concentration and innovation
I
If concentration is high, increasing competition helps to increase
innovation
I
If concentration is low, further reduction of concentration will decrease
innovation
Possible intuition:
I
When concentration is high, replacement effect is strong ⇒ less
concentration helps
I
When concentration is very low, further reducing it might destroy
expected profits after innovation ⇒ more concentration hurts
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