Research and Development Chapter 22 Research and Development
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Research and Development Chapter 22: Research and Development 1
Introduction • Technical progress is the source of rising living standards over time • Introduces new concept of efficiency – Static efficiency—traditional allocation of resources to produce existing goods and services so as to maximize surplus and minimize deadweight loss – Dynamic efficiency—creation of new goods and services to raise potential surplus over time Chapter 22: Research and Development 2
Introduction 2 • Schumpeterian hypotheses (conflict between static and dynamic efficiency) – Concentrated industries do more research and development of new goods and services, i. e. , are more dynamically efficient, than competitively structured industries – Large firms do more research & development than small firms Chapter 22: Research and Development 3
A Taxonomy of Innovations Product versus Process Innovations • Product Innovations refer to the creation of new goods and new services, e. g. , DVD’s, PDA’s, and cell phones • Process Innovations refer to the development of new technologies for producing goods or new ways of delivering services, e. g. , robotics and CAD/CAM technology • We mainly focus on process or cost-savings innovations but the lines of distinction are blurred—a new product can be the means of implementing a new process Chapter 22: Research and Development 4
A Taxonomy of Innovations 2 Drastic versus Non-Drastic Innovations • Process innovations have two further categories • Drastic innovations have such great cost savings that they permit the innovator to price as an unconstrained monopolist • Non-drastic innovations give the innovator a cost adavantage but not unconstrained monopoly power Chapter 22: Research and Development 5
Drastic versus Non-Drastic Innovations • Suppose that demand is given by: P = 120 – Q and all firms have constant marginal cost of c = $80 • Let one firm have innovation that lowers cost to c. M = $20 • This is a Drastic innovation. Why? – Marginal Revenue curve for monopolist is: MR = 120 – 2 Q – If c. M = $20, optimal monopoly output is: QM = 70 and PM = $70 – Innovator can charge optimal monopoly price ($70) and still undercut rivals whose unit cost is $80 Chapter 22: Research and Development 6
Drastic versus Non-Drastic Innovations 2 • Now consider the case if cost fell only to $60, innovation is Non-drastic – Marginal Revenue curve again is: MR = 120 = 2 Q – Optimal Monopoly output and price: QM = 30; PM = $90 – However, innovator cannot charge $90 because rivals have unit cost of $80 and could under price it – Innovator cannot act as an unconstrained monopolist – Best innovator can do is to set price of $80 (or just under) and supply all 40 units demanded. Chapter 22: Research and Development 7
M < QC Non. Drastic Innovation: Q M > QC so Drastic Innovation: Q Drastic vs. Non-Drasticso. Innovations innovator cannot 3 charge innovator can charge monopoly M because rivals monopoly price P M Innovation is drastic if monopoly output Q at MR = new marginal price PM without constraint c’ exceeds the competitive output QC atcan oldundercut marginalthat costprice c $/unit = p c PM c’ Demand MR QC QM MR Quantity QM QC Chapter 22: Research and Development Quantity 8
Innovation and Market Structure • Arrow’s (1962) analysis— – Innovative activity likely to be too little because innovators consider only monopoly profit that the innovation brings and not the additional consumer surplus – Monopoly provides less incentive to innovate that competitive industry because of the Replacement Effect • Assume demand is: P = 120 – Q; MC= $80. Qisis. Yellow initially 40. Initial Surplus Innovator lowers cost to $60 and can sell all 40 units at P = $80. Gains from • Profit Gain is $800–Less than. Triangle--Social Gain Innovation are Areas A ($800) and B ($200) But Innovator Only Considers Profit Area A ($800) $/unit 120 80 60 A B 40 60 120 Chapter 22: Research and Development Quantity 9
Innovation and Market Structure 2 • Now consider innovation when market structure is monopoly – Initially, the monopolist produces where MC = MR = $80 at Q = 20 and P = $100, and earns profit (Area C) of $400 – Innovation allows monopolist to produce where MC = MR = $60 at Q = 30 and P = $90 and earn profit of $900 – But this is a gain of only $500 over initial profit due to Replacement Effect—new profits destroy old profits $/unit 120 Monopolist Initially Earns 100 C Profit C—With Innovation it 90 Earns Profit A—Net Profit 80 60 A 20 30 MR 60 Gain is Area A – Area C Which is Less than the Gain Demand to a Competitive Firm 120 Chapter 22: Research and Development Quantity 10
Innovation and Market Structure 3 • Preserving Monopoly Profit--the Efficiency Effect • Previous Result would be different if monopolist had to worry about entrant using innovation – Assume Cournot competition and that entrant can only enter if it has lower cost, i. e. , if it uses the innovation – If Monopolist uses innovation, entrant cannot enter and monopolist earns $900 in profit – If Monopolist does not use innovation, entrant can enter as lowcost firm in a duopoly • Entrant earns profit of $711 • Incumbent earns profit of $44 – Gain from innovation now is no longer $900 - $400 = $500 but $900 - $44 = $856 – Monopolist always has more to gain from innovation than does entrant—this is the Efficiency Effect Chapter 22: Research and Development 11
Competition and Innovation • The incumbent/entrant model just discussed seems closer in spirit to Schumpeter’s ideas than Arrow’s analysis. • Dasgupta and Stiglitz (1980) come even closer by directly embedding innovation in a model of Cournot competition – – – Profit for each firm: i = P(Q) – c(xi)qi – xi Here, firm’s unit cost falls as the firm engages in R&D activity What is the equilibrium? Define x* as the optimal R&D level of each firm From Chapter 9, we know that –But with n symmetric firms si = 1/n, So we have Output Condition Chapter 22: Research and Development 12
Competition and Innovation 2 • How much should x* be? – The usual marginal calculations apply. Every increase in x costs $1. The benefit is the cost reduction this brings, c(x)/ x, times the number of units q* to which this cost reduction will apply R&D Condition – Both the Output Condition and the R&D Condition must hold simultaneously in any equilibrium – One obvious implication of the R&D Condition is that the R& D effort of any one firm will fall as the number of n firms increases because this will decrease the output of each firm Chapter 22: Research and Development 13
Competition and Innovation 3 • Making n endogenous means allowing firms to enter until they no longer have an incentive to do so • This will occur when firms earn zero profit after allowing for R&D costs. Defining n* as the equilibrium number of firms, the Output Condition then implies: • Substitution into the R&D Condition then yields: Industry R&D as Share of Sales • Industry R&D effort declines as n* rise, i. e. , as industry becomes less concentrated—fairly strong theoretical support for Schumpeterian Hypothesis Chapter 22: Research and Development 14
Competition and Innovation 4 • But empirical support for Schumpeterian view is mixed – Need to control for science-based sectors (e. g. , chemicals, pharmaceuticals, and electronics) and non-technology based sectors (e. g. , restaurants and hair stylists)—R&D much more likely in science-based sectors regardless of firm size – Need also to distinguish between R&D expenditures and true innovations. Common finding [e. g. , Cohen and Klepper (1996)], is that large firms do somewhat more R&D but achieve less real innovative breakthroughs—e. g. , Apple produced the first PC – Market structure is endogenous. Innovations might create industry giants (e. g. , Alcoa) not the other way around. • Bottom Line: Validity of Schumpeterian hypotheses is still undetermined Chapter 22: Research and Development 15
R&D Spillovers and Cooperative R&D • Technological break-throughs by one firm often “spill over’ to other firms – Spillover is unlikely to be complete but likely to arise to some extent – We can model this in the Dasgupta Stiglitz world by now writing a firm’s unit cost as a function of both its own and its rival’s R&D • c 1 = c – x 1 - x 2 • c 2 = c – x 2 - x 1 • To obtain solution, need also to assume that R&D is subject to diminishing returns, e. g. , r(x) = x 2/2. Chapter 22: Research and Development 16
R&D Spillovers and Cooperative R&D 2 • In this setting, response of firm 1’s R&D to firm 2’s R&D depends on size of spillover term . – When is small, R&D expenditures are strategic substitutes —the more firm 1 does the less firm 2 will do – When is large, R&D expenditures are strategic complements—the more firm 1 does the more firm 2 will do • However, determination of whether R&D efforts are strategic substitutes or strategic complements is not sufficient to determine what happens when there are spillovers Chapter 22: Research and Development 17
R&D Spillovers and Cooperative R&D 3 • Let Demand be given by: P = A – BQ – Let ci = c – xi – xj; – Each firm now chooses both production qi and research intensity xi • General Solution is: • To illustrate, consider two cases – First case: Low Spillovers; = 0. 25 – Second case: High Spillovers; = 0. 75 Chapter 22: Research and Development 18
quilibrium is for both firms to the high level of research R&D Spillovers and Cooperative R&D 4 y (x = 10). Why? When degree Thethat Pay-Off Matrix for = 0. 25 overs is small, firm know can do R&D knowing that it most of the benefits. Since this Firm 1 advantage the rival, each firm avoid being left behind by doing Low Research High Research R&D itself. Intensity Low Research $107. 31, $107. 31 $100. 54, $110. 50 Intensity Firm 2 High Research $110. 50, $100. 54 $103. 13, $103. 13 Intensity Chapter 22: Research and Development 19
sh Equilibrium is for both firms to oose the low level of research intensity = 7. 5). Why? When. Spillovers degree of R&D and Cooperative R&D 5 llovers is large, a firm knows that it The Pay-Off Matrix for = 0. 75 l benefit from technical advance of its al even if it doesn’t do any R&D itself. Firm 1 each firm tries to free-ride off its rival d each does little R&D itself. Low Research High Research Intensity Low Research $128. 67, $128. 671, $136. 13, $125. 78 Intensity Firm 2 High Research $125. 78, $136. 13 Intensity Chapter 22: Research and Development $133. 68, $133. 68 20
R&D Spillovers and Cooperative R&D 6 • MORAL of the foregoing analysis is that the Outcome of non-cooperative R&D spending depends critically on the extent of spillovers. • What if R&D spending is cooperative? • R&D cooperation can take two forms: – 1. Do R&D independently but choose x 1 and x 2 jointly to maximize combined profits, given competition in product market is maintained. – 2. Do R&D together as one firm, e. g, form a Research Joint Venture. That is, effectively operate as though the degree of spillovers is = 1, again though, continue to maintain product market competition. • The two types have very different implications. Chapter 22: Research and Development 21
R&D Spillovers and Cooperative R&D 7 • Consider first the case of coordinated but not centralized R&D using our generalized demand cost equations – Total R&D spending now rises unambiguously as increases. – To see this note that given our earlier demand cost assumptions, and given the fact that x 1 and x 2 are chosen to maximize joint profits, the optimal values for x 1 and x 2 are: Chapter 22: Research and Development 22
R&D Spillovers and Cooperative R&D 8 • This solution for the profit-maximizing research level under cooperation is unambiguously increasing in but this is a good news/bad news story. • The good news is that for the high spillover case ( >1), the free- riding problem is no longer an issue and firms now do more R&D • The bad news is that for the low spillover case ( < 1), there is no longer a fear of being left behind by one’s rival. So in this case firms do less R&D which means costs (and consumer prices) are higher than without cooperation. Chapter 22: Research and Development 23
R&D Spillovers and Cooperative R&D 9 • What about a Research Joint Venture? – As noted, this effectively changes to 1. – For our demand cost equations, it can be shown that: – This is clearly more R&D than occurred with simple coordination for any given value of – As a result, it leads to lower costs and more output to the benefit of consumers – Profits are also higher. Thus, in the presence of spillovers, Research Joint Ventures are unambiguously beneficial. – The only trick is to make sure that cooperation is limited to research and does not extend to other dimensions of competition Chapter 22: Research and Development 24
Empirical Application: International Spillovers in R&D • Perhaps we can get evidence on the extent of R&D spillovers by looking at technology spillovers between the same industry across different countries • This is the strategy employed by Keller (2002) • Consider output in industry i and country c – ln Qci = (1 – )n Kci + ln Lci – Or: Total Factor Productivity in country c and industry i is: – TFPci = ln Qci – (1 – )n Kci + ln Lci Chapter 22: Research and Development 25
Empirical Application: International Spillovers in R&D 2 • Using bars to denote average industry i levels across the entire sample, Keller measures the relative factor productivity in industry i country c then as follows: • This equation measures relative productivity at a point in time. • Keller measures Fci for each of 12 industries in 14 countries over the years 1970 to 1995. • He thus has productivity observations that vary across space and time Fcit • He seeks to explain the observed changes in productivity in each industry/contribution over time on the basis of domestic and foreign R&D Chapter 22: Research and Development 26
Empirical Application: International Spillovers in R&D 3 • Keller divides his 14 countries into two groups – Engines of technical change: France, Germany, Japan, UK and US – Nine Others: Australia, Canada, Denmark, Finland, Italy, the Netherlands, Norway, Spain, and Sweden • He asks how relative factor productivity in industries in each of the nine depends on their own R&D and the R&D in the 5 engines of technical change countries, the G 5 • In particular, Keller supposes that the relevant technical base for any of the 12 industries in any of the nine countries is a function of its own R&D and R&D in the G 5 Chapter 22: Research and Development 27
Empirical Application: International Spillovers in R&D 4 • Let Scit be the amount of R&D done up to year t in country c and industry i. • Keller says that this contributes to a nation’s relative factor productivity according to the following equation • Here measures the productivity impact of (the log) of all R&D relevant to the domestic industry’s relative productivity • That relevant R&D is comprised of two parts • Domestic R&D Scit contributes directly to productivity • R&D in the G 5 contributes less directly if is less than one and the effect is weaker for countries farther away as measured by distance D if is positive Chapter 22: Research and Development 28
• Empirical Application: International Spillovers in R&D 5 Keller (2002) uses nonlinear estimation techniques to estimate the parameters , , and jointly after controlling for country-specific and time-specific effects. His basic results are Coefficient Estimate 0. 078 1. 005 0. 843 Std. Error (0. 013) (0. 239) (0. 059) • All these effects are statistically significant. – Own country R&D raises productivity by roughly 7. 8 percent if there is no G 5 R&D – G 5 R&D is 84. 3 percent of domestic R&D but the 1. 005 value for implies that his effect declines rapidly as the G 5 country is farther away and disappears entirely once that distance reaches 400 miles • However, once Keller allows for differential impacts depending on which G 5 country does the R&D the spillover lasts up to 1200 miles. Such extensive spillovers between nations suggests that R&D spillovers between firms are probably significant Chapter 22: Research and Development 29
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