Research and Development
Lecture 10

Schumpeter's Hypothesis

1. Schumpeter's Hypothesis

• Capitalism is always changing; not stationary

  • New goods

  • New products

  • New enterprises

  • New forms of industrial organization

• Creative destruction - new economic structure replaces the old

• Kondratieff Cycle - economic cycles last from 50 to 60 years

  • Severe depressions occur at the toughs

  • Western Societies

    • First Cycle (1780 to 1840) - water power drove the industrial revolution in textiles

    • Second Cycle (1840 to 1890) - steam power and railroads formed the second industrial revolution

    • Third Cycle (1890 to 1940) - the rise of steel, electricity, and communications

    • Fourth Cycle (1940 to 1990)

      • Mass production

      • Radio and TV

      • Interstate highway system

      • Air transportation

    • Fifth Cycle (1990 to present)

      • Computers (since 1980s)

      • E-commerce (1990s)

• Schumpeter's Hypothesis

  • Pure competition is impossible

  • Monopolies grow and develop over time until they control production

  • Capitalism would collapse from its own success

2. Support of Schumpter's Hypothesis

• Large firms have more resources

• Large firms have economies of scale in research and development

• Large firms can diversify projects

• However, large firms become bureaucratically inefficient

• Example - International Business Machines (IBM)

  • Specialized in mainframes and minicomputers

  • Thought the PC would be a small market

  • IBM management was slow and cumbersome

  • Steve Jobs and Steve Wozniak built the first Apple computer in parent's garage

  • Bill Gates wrote software for the PC

3. Empirical Evidence

• Test two hypothesis

  • Larger firms invest more into research

    • Difficult to measure level of knowledge

    • Number of patents

    • Expenditures on research

    • Number of scientists and researchers

  • Innovation and a firm's size should correlate positively

• The empirical evidence is mixed - some industries conform to hypothesis while other industries do not

• Why?

  • A firm does need some monopoly power

  • Ease of entry; potential competition

  • Entrepreneurial leaders

  • Type of industry matters

    • Many advances in medicine and computers

    • Few advances in brick and glass manufacturing

  • Firm has ability to maintain control over technology

    • Computer chips - difficult to reverse engineer and produce

    • Software - easy to reverse engineer and replicate

  • Innovation and firm size has an upside down u-shape

Technological Changes

1. Definitions

• Basic Research - scientist gain knowledge

  • Academic and nonprofit institutions

  • Private companies

• Applied Research - use knowledge for commercial purposes

  • Private companies

  • Example: companies are researching vaccines for HIV/AIDS

• Invention - a discovery or device that should work

• Diffusion - the act of dispersing

  • Knowledge comes into common usage

2. Market Structure

• Competitive markets

  • Have an incentive to innovate

  • Competition drives profits to zero

  • Diffusion occurs rapidly

  • Unfortunately, competitive markets may not be innovative

• Monopoly

  • Could earn long-run profits

  • Has profits to invest in research and development

  • Monopolist is not worried about losing consumers

  • No competitors

  • A monopolist may not keep up with technology

• Oligopoly

  • May not earn as much long-run profits as a monopoly

  • Has an incentive to invest in research and development

3. Present Value

• You will receive $100,000 in 100 years
• You rather have the money today
• The interest rate (or discount rate) is 5%
• The value of the money is:

• It is worth $769.45 to you today
• You could deposit $760.45 in a bank today at 5% interest, and it will grow into $100,000 in 100 years

• We use the present value to evaluate market value of securities
  • Alter payment arrangement, etc.
  • Used to calculate mortgages, bond prices, annuities, etc.
• Example
  • You want to travel to Europe today
  • You get $10,000 from a trust fund per year for 10 years
  • A finance company offers to cash out your trust fund for 6% per year interest

4. Cost and Benefits of Research

• Costs and benefits of research accrue over time

• C _n is the cost in period n

• r is the discount rate

• C _pv is the present value of the research cost

  • A firm pays research costs over time

  • All costs are discounted to the present

• Most costs are front loaded

  • The firms pay a greater cost to develop new product or service

  • Year 0: C _PV is the greatest

  • Year 1: C _PV loses the C ₀ term and it is smaller

  • Year 2: C _PV loses the C ₀ and C ₁ terms, and becomes smaller

• Graph of the C _PV function is below:

• B is the benefit of a new product or technology

  • B _pv is the present value of the benefit

  • B _n is the benefit in period n

• Rapid rate of technological advancement

  • Makes the early benefits greater

  • Later benefits are discounted

  • Firms with breakthroughs have an advantage over other firms

  • Competitors will try to match the technology

• Graph the present value of costs and benefits over time

  • B _pv is downward sloping because the benefits are the greatest when development time is short

  • C _pv is the costs decrease as the development time become longer

  • Use calculus to find the optimal time of development, which is t*

• Assume firms have the same costs under all market structures

• Market structure affects the benefit

  • Competitive markets develop products quickly and implement technology quickly

    • Present value of benefits is Bc

    • Competitive markets see the highest benefits in the beginning

    • High diffusion

    • Optimal time for development is tc

    • Year 0: B _PV is the largest

    • Year 1: B _PV is smaller because B ₀ term is gone

    • Year 2: B _PV is smaller because B ₀ and B ₁ terms are gone

  • Monopolies develop products slowly

    • Present value of benefits is Bm

    • Monopoly realizes the greatest benefits over time

    • Optimal time for development is tm

  • Oligopolies are in between

    • Present value of benefits is Bo

    • Optimal time for development is to

• Graph is shown below:

5. Dominant firm with competitive fringe

• Dominant firm – a firm possess market power

• Competitive fringe – small firms in market that keep the dominant firm competitive

• Example: Microprocessors

  • Intel has 80% of market

  • Competitive fringe AMD

  • VIA Chinese dragon chip

  • Intel is More efficient than rivals

  • Why?

    • Extensive economies of scale

    • Produces superior product

    • Dump billions into research and development

    • New factory cost billions of dollars

• Dominant firm must stay ahead to remain dominant

• Firms that were dominant

  • Kodak in film

  • U.S. steel industry

  • Xerox

  • Harley Davidson – motorcycles

6. Game theory

• We have two pharmaceutical companies, GSK and Merck, and they participate in a simultaneous game.

• The strategies are:

  • Innovate: If a company pays 5 units to develop a new drug

  • Imitate: One company pays zero units to reverse engineer the other company's new breakthrough drug

  • The payout is the cost, which is shown below in the matrix:

• Dominate strategy for both companies is to imitate

• The Nash equilibrium is imitate-imitate

Economics of Patents and Copyrights

1. Patent - grants the right to an inventor or scientist the exclusive right to sell, produce, or withhold invention

• Malaysia and United States: patent is for 20 years

• Once the patent expires, any company can produce and sell the product

• Some companies do not file patents

  • Patent is a public record

  • Other companies can review patent and try to improve it

  • Some countries like China violate patents

2. Scenario 1

• Scientist discovers a new drug

• The holder of the patent can only produce and sell the new drug

  • Scientist could retain the patent and start a company

  • Scientist could sell his right to a company

  • The scientist's employer may hold the right of the patent

• Entry barrier

  • The patent grants a monopoly right for 20 years

  • The company sells the medicine for a price above marginal costs

  • The monopolist can grow into a powerful entity even after the patent expires

  • The scientist may obtain patents that are similar to original patent to prevent competition

• Competitors can try to invent something similar by inventing around the patent

  • If the competitors are not successful, then patent encourages the growth of a monopoly

  • Patent may hinder technological advancement

• Note - Some U.S. pharmaceutical companies stopped producing particular drugs when the patent expired

  • They introduced new drugs that were not as effective

  • They pay to prevent generic medicines from entering the market

3. Scenario 2

• A country does not issue patents

• A scientist develops a new drug and a company is interested in producing it

• A company quickly produces and sells the drug to the public

  • The company sells the drug above marginal cost initially

  • The company has an incentive to keep improving the drug

• Competitors can quickly form to produce and sell the new drug

• The industry adapts technology quickly and profits are driven to zero much quicker than a patent system

4. Scenario 3

• A country does not issue patents

• Scientist develops a new drug

• Companies are not interested in the new drug

  • The companies believe the development cost is too high

  • They cannot recoup their costs

• Society does not benefit from the scientist's invention

5. Scenario 2 is the best while Scenario 3 is the worse

• Some inventions are patent dependent while others are not

• Empirical evidence suggests most inventions are not patent dependent

6. Copyright - protection for artists

• Books, music, films, and software

• United States - protection is creator's life plus 70 years

• Copyright varies for countries

• Developed countries have strong legal protection for copyrights

• Developing countries have weak protection

  • China - counterfeit music, movies, software, and pharmaceuticals

  • Citizens in developing countries may not have the income to pay for the full price

  • Chinese firms may have lower costs because they do not pay full price for copyrighted media

Economics of X-Inefficiency and Research Monopolies

1. A monopolist faces the demand function, P = 50 - Q. Its long-run AC = MC = 25. The monopolist develops new technology that allows it to lower its long-run AC = MC = 20. How much will the monopolist's profits increases?

(a) Solve for the monopolist's profits before and after the innovation.

(b) Solve for the market prices under both scenarios

(c) Solve for the profits under both scenarios, and calculate the difference. The graph is also shown below:

(d) What happens if this market is purely competitive? The P = MC = 25, so we solve for the quantity, which is Q = 50 - P = 50 - 25 = 25

For the competitive market, the patent holder would earn a profit to compensate him or her for their innovation. The competitive market still has to pay to develop and implement the innovation. Thus, the market price remains at 25 and market quantity remains at 25.

The patent holder would earn the difference in price multiplied over the number of units, or

The competitive market supplies more quantity for a lower price than the innovative monopoly.

2. A problem comparing a purely competitive market, monopoly, x-inefficiency, and research monopoly

(i) Solve for a purely competitive market

• Use P = MC rule

  • MC = 10

  • Thus, C(Q) = 10 Q

  • Set P _C = MC = 10

• Use demand function

  • P = 100 – Q

  • 10 = 100 – Q _C

  • Thus, Q _C = 90

• Consumers' surplus = 0.5 (100 – 10)(90 – 0) = 4,050

• Profits = P Q – C(Q) = 10 (90) – 10 (90) = 0

• DWL = 0, because competitive market

(ii) Solve for monopoly with no x-inefficiency

• Solve for marginal revenue (MR)

• Thus, MC = 10

• Set MR = MC

  • 100 – 2Q = 10, so Q _M = 45

• Price

  • P = 100 – 45 = 55

• Consumers' surplus = 0.5 (100 – 55)(45 – 0) = 1,012.50

• Profits = PQ – C(Q) = 55(45) – 10 (45) = $2,025.00

• DWL = 0.5 (55 – 10)(90 – 45) = 1,012.50

(iii) X-inefficiency – monopoly may have higher costs than competitive firm

• Workers are not motivated

• Management problems

• Lack of competition

• No incentive to minimize costs

• Example: Demand function is P(Q) = 100 – Q

• Solve for monopoly with x-inefficiency

  • Thus marginal cost rises to MC _X = 20

  • Set MR = MC

• Solve for market quantity

  • 100 – 2Q = 20, so Q _X = 40

• Solve for the market price

  • P = 100 – 40 = 60

• Consumers' surplus = 0.5 (100 – 60)(40 – 0) = 800.00

• Profits = PQ – C(Q) = 60(40) – 20 (40) = $1,600.00

• DWL = 0.5 (60 – 20)(80 – 40) = 800.00

(iv) Research Monopoly

• Monopoly can earn substantial profits

• Could invest into research and development or expand economies of scale

  • Thus, the marginal costs become lower

• Assume MC _R = 5

• Set MR = MC

  • 100 – 2Q = 5, so Q _R = 47.5

• Price

  • P = 100 – 47.5 = 52.50

• Consumers' surplus = 0.5 (100 – 52.5)(47.5 – 0) = $1,128.125

• Profits = PQ – C(Q) = 52.5(47.5) – 5 (47.5) = $2,256.25

• DWL = 0.5 (52.5 – 5)(95 – 47.5) = 1,128.125

Results

• Competitive market gives highest social welfare

• Monopoly with x-inefficiency gives the lowest

• Research monopoly is better than other monopolies