Research and Development

Innovations and
Patents
Economic growth is caused
primarily by technological
progress (the Solow model of
growth).
R&D is the engine of
technological change.
Firms become industry leaders
by conducting R&D that leads to
innovations in products and
processes.
Schumpeter coined the phrase
creative destruction to refer
to the capitalist system.
Periodically, new products and
processes are developed which
destroy the market power of old
products and processes.


What is R&D?
Basic Research: Does not lead directly
to new product or process, but
improves fundamental knowledge.
Applied Research: Involves substantial
engineering input and results in new
product or process.
Development: Move product/process
to consumer market/mass production.

What is R&D, cont
Process innovations: better method
for producing existing product.
Product innovations: new product.
Drastic innovation: dramatically
reduce costs to extent that innovator
essentially becomes a monopolist.
Non-drastic or gradual innovation:
improves firms competitive position,
but there still is competition.
Innovation
A better way of doing
things
An improvement
1
st
Cell Phone
March 6, 1983
Razr 2006
Alexander
Graham Bells
Phone
1876
Old Phone
Telephone
Old
Computers
Dell
Computers
2006
A Drastic Innovation
New MC
MR
$
Quantity
D
MC for
industry
P
C

Q
C
P
M
Q
M
A Non-Drastic Innovation
New MC
MR
$
Quantity
D
MC for
industry
P
C

Q
C
P
M
Q
M
R&D and Market
Structure
What market structures are most
conducive to R&D?
Early View (Schumpeterian Hypothesis):
R&D generally conducted by large firms.
R&D generally conducted in industries with
market power.
Thus, markets with large firms and market
power not necessarily bad as this would
encourage R&D and innovation.
Market Structure and
the Incentive to Innovate
Is the Schumpeterian Hypothesis
correct? Are incentives for R&D affected
by market structure?
Start with a basic inverse demand curve:
P= A-BQ.
We want to consider an innovation that
could increase social welfare and then see
whether market structure affects
whether such an innovation will occur.
Arrow Model of Mkt.
Structure & Innovation
Assume that the innovation would cost K
to research and develop.
The result of the innovation is an
improvement in the production process so
that the constant marginal cost of
production drops from c
0
to c
1
.
Compare expenditure, K, to potential
increase in surplus from change in MC,
(appropriately discounted to account for
increased surplus in the future as well).
The Welfare Effects of an Innovation
C
1
$
Quantity
D
C
0

CS
Arrow Model, cont
In a competitive market, a firm will only
innovate if the cost of innovation is less
than the increased profit as a result of
the innovation.
Consider a perfectly competitive market.
If the innovation could be adopted by
other competitors, there would be no
increase in profit. All firms would adopt,
but because of perfect competition, price
would drop to equal the new lower cost.
Arrow Model, cont
If the market is perfectly competitive
but the innovation is not adoptable, the
firm will be able to make profit as a result
of the innovation.
The firm can undercut the competitive
price by a couple of cents and supply
essentially the entire market.
Increase in Profit in a Competitive Market
from a Non-Adoptable Innovation
C
1
$
Quantity
D
C
0
Innovators
price
Increase
in Profit
Note that the increase in profit
is less than the increase in
potential welfare
Increase in Profit in a Monopoly from
Innovation
C
1
$
Quantity
D
C
0
Innovators
price
Note that the increase in profit for the
monopolist (the area of the blue box
minus the area of the yellow box) is less
than the increase in profit for the firm
in a competitive market.
MR
Arrow Model, cont
A monopolist will actually value the
innovation less than a competitive firm.
The monopolist was already making profit,
already had some market power. This is
known as the replacement effect.
Even with more complex models, general
result is that the more competitive the
market, the more gains to an innovator.
In all cases, firms undervalue innovation
compared to effect on total surplus.
Arrow Model, cont
Is the Schumpeterian Hypothesis wrong?
Are gains from innovation inversely related
to market power?
Market power pre-innovation makes the
post-innovation gain smaller.
But we assumed that post-innovation the
market would be a monopoly, regardless of
the pre-innovation structure.
Also, we said nothing about the market for
innovation itself.

Another Model of Mkt.
Structure & Innovation
Suppose that there are two potential
innovators, an incumbent monopolist with
technology c
0
and a potential entrant.
Assume the innovation is non-adoptable, so
that the first firm to innovate can lower
marginal costs to c
1
at a cost of K.
If the potential entrant innovates first, he
becomes the low-cost firm in a duopoly. His
return to innovation is
D
(c
1
,c
0
) - K.
Another Model of Mkt.
Structure & Innovation
If the monopolist is the first innovator, he
will retain his monopoly and earn profits of

M
(c
1
) - K.
If the monopolist does not innovate, the PE
will, so the monopolist will get
D
(c
0
,c
1
).
Thus the return to innovation for the
monopolist is
M
(c
1
)-
D
(c
0
,c
1
) - K.
For the PE, the return is
D
(c
1
,c
0
) - K.

Another Model of Mkt.
Structure & Innovation
As long as
M
(c
1
)-
D
(c
0
,c
1
) - K >
D
(c
1
,c
0
) - K
the return to innovation is greater for the
monopolist than for the PE.
Rewrite this condition:

M
(c
1
) >
D
(c
1
,c
0
) +
D
(c
0
,c
1
).
Which says that if the profit to a
monopolist is greater than the joint profit
of duopolists, the gain to innovation is
greater for a monopolist. And it is.
This is known as the efficiency effect.
Schumpeter Revisited
Is the Schumpeterian Hypothesis wrong?
It depends on the nature of competition.
If the firm starts with market power, the
increase in market power due to an
innovation will not be as large as if the firm
started without market power.
However, firms with market power have
greater incentives to innovate to protect
their existing market power.

Even More Evidence: the
Dasgupta/Stiglitz Model
Consider a slightly more sophisticated model
where all firms in the industry can innovate
simultaneously.
Assume firms compete through quantity.

i
= P(Q)q
i
- c(x
i
)q
i
- x
i
where x is the firms
expenditure on R&D.
If all firms spend the same amount, x*, on
R&D, all firms have the same cost c(x*).
Solve just as we would any n-firm Cournot
model.
Dasgupta/Stiglitz cont
We then get the following expression of the
equilibrium quantity for each firm in this
market:
q* = (a-c(x*))/(b(n+1)).
To determine the optimal level of R&D, take
the derivative of profit w.r.t. x
i
and set
equal to 0.

i
= P(Q)q
i
- c(x
i
)q
i
*- x
i
, so the derivative is:
-(dc(x
i
)/dx
i
)q
i
* - 1 = 0.
Dasgupta/Stiglitz cont
What does -(dc(x
i
)/dx
i
)q
i
* - 1 = 0 mean?
Remember that dc(x
i
)/dx
i
is the decrease in
marginal cost due to an additional dollar
spent on R&D. So the first term is the
total benefit of an additional dollar spent on
R&D.
In equilibrium, this total benefit must be
equal to the cost of the additional R&D, i.e.
$1.
Dasgupta/Stiglitz cont
But the important thing to note is that the
marginal benefit -(dc(x
i
)/dx
i
)q
i
* , depends
on q*.
And q* depends on the number of firms in
the industry: q* = (a-c(x*))/(b(n+1)).
The more firms, the lower is q* and thus
the lower the benefit from R&D.
A lower benefit means less R&D spending, so
the more firms in the industry, the less
spending by each firm on R&D.
Dasgupta/Stiglitz cont
How will total industry spending, nx*, be
affected by concentration?
Total spending may increase or decrease as
industry size increases, depending on the
elasticity of demand in the industry.
However, in most cases, increasing the
number of firms leads to less industry
spending.
R&D and Market Power
How do we balance the potential positive
aspects of market power (w.r.t. R&D and
innovation) with the positive aspects of
less concentrated markets (w.r.t.
efficiency)?
Key is to recognize the dynamic aspect of
the process. We want to increase
efficiency over time which may require a
settling for less efficiency in the short
run.
Public Policy w.r.t. R&D
What policies best encourage the
discovery of new products and processes?
What policies best encourage
dissemination of new ideas and
technologies?
Patents
Provide inventors with
exclusive rights to
manufacture a device for a
period of time that has been
fixed.
Assigned to individuals, not
corporations.
Patents Cont.
The inventor must keep dated
logs in order to prove who
invented something first.
Patent Pending the inventor
has applied for a patent, but
not received it yet.

Patents and Copyright
Patents and copyright confer property
rights to new inventions, new designs, and
new creative works.
The property rights allow the innovator to
exert monopoly power, which acts as an
incentive to encourage R&D and innovation.
However, to achieve the efficiency gains
from the innovation, it must be used
widely, so the property rights must be
terminated at some point.
Effect of Patent on Surplus
$
Quantity
D MR
This surplus goes to producer
over length of patent, then
transfers to consumers (B)
This surplus goes to consumers
when patent expires (C)
This surplus goes to consumers (A)
Q
P
Q
C
What is the optimal
patent length?
If T is the length of the patent, then the
producer gets B (from the graph) for T
years-appropriately discounted of course.
The consumers get the A each year, plus
the B and C for all years after T.
Note that after T years, B just transfers
from the producer to the consumer.
Real gain in surplus is C, which we get
after the patent expires.
What is the optimal
patent length, cont
The shorter T, the sooner we get C.
However, the producer decides whether
to innovate based on the increased profit,
i.e. how long he gets the surplus in B.
The longer T, the more incentive to
innovate and the bigger are A, B, and C.
Optimal patent length balances these two
effects.
Optimal Breadth of
Patents
Breadth is the amount by which innovation
must differ from an existing product or
process.
The more broad a patent is, the harder it
is to invent around the patent and thus
the more profit the producer can get.
Related to optimal length -- i.e. could have
short and fat patents or long and thin.
Trademarks
Trademarks give an individual or
corporation a right to identify a
product with a graphic symbol that
customers can readily recognize for
the quality and service they have
earned.
Generally, a trademark has no time
limit.
Trademark Examples
Adidas
Mountain Dew
Abercrombie & Fitch
Nike
Copyrights
Provide the creators of
written materials the right to
a profit from the sale of
their works for a definite
period of time.
Related to written material,
graphic material, or music.
Licensing Is
3
8
Timeline
Disclosure
Evaluation
IP Protection
US and Foreign Patent Maintenance
Status Reporting
Marketing
7 mos.
14 mos.
6.5 yrs
14 yrs
20 yrs
20+ yrs
A Framework For Thinking About
the Role of Innovation in
Entrepreneurship
Applied
Research
Basic Science
Research
Commercial-
ization
Public R&D
investment
Private R&D
investment
Public R&D
investment
Private R&D
investment
Patents

Anti-trust

Existing Firms
New Firms
Anti-trust Law and
Innovation
The goal of anti-trust law is to prevent
monopolies and improve economic welfare

There are benefits to cooperation which
must be weighed in
Cross-licensing
Commercialization