Chap011W Rev

Chapter 11W - Technology, R&D, and Efficiency
Chapter 11W Technology, R&D, and Efficiency
QUESTIONS
1. What is meant by technological advance, as broadly defined? How does technological advance
enter into the definition of the very long run? Which of the following are examples of
technological advance, and which are not: an improved production process; entry of a firm into a
profitable purely competitive industry; the imitation of a new production process by another firm;
an increase in a firm’s advertising expenditures? LO1
Answer: Technological advance is broadly defined as new and better goods and services
and new and better ways of producing or distributing them. There is a distinction
between the “long run” and the very “long run”: In the long run, technology is constant
but firms can change their plant sizes and are free to enter or exit industries. In contrast,
the very long run is a period in which technology can change and in which firms can
introduce entirely new products.
(a) An improved production process; Yes (innovation)
(b) Entry of a firm into a profitable purely competitive industry; No
(c) The imitation of a new production process by another firm; Yes (Diffusion)
(d) An increase in a firms advertising expenditures; No
2. Listed below are several possible actions by firms. Write “INV” beside those that reflect
invention, “INN” beside those that reflect innovation, and “DIF” beside those that reflect
diffusion. LO1
a. An auto manufacturer adds “heated seats” as a standard feature in its luxury cars to keep pace
with a rival firm whose luxury cars already have this feature.
b. A television production company pioneers the first music video channel.
c. A firm develops and patents a working model of a self‐erasing whiteboard for classrooms.
d. A light bulb firm is the first to produce and market lighting fixtures with LEDs (light emitting
diodes).
e. A rival toy maker introduces a new Jezebel doll to compete with Mattel’s Barbie doll.
Answer:
(a) DIF: Another firm was already using heated seats in their automobiles
(b) INN: A new way of using existing technology
(c) INV: A new product
(d) INN: A new way of using existing technology
(e) DIF: Another firm was already producing a doll using a given technology
3. Contrast the older and the modern views of technological advance as they relate to the
economy. What is the role of entrepreneurs and other innovators in technological advance? How
does research by universities and government affect innovators and technological advance? Why
do you think some university researchers are becoming more like entrepreneurs and less like
“pure scientists”? LO2
11W-1
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whole or part.
Answer: The older view of technological advance was that it was external to the
economy; a random outside force to which the economy adjusted. Scientific and
technological advances were fortuitous and helpful but largely external to the market
system. Most contemporary economists have a different view. They see capitalism itself
as the driving force of technological advance. In this view, invention, innovation, and
diffusion occur in response to incentives provided by the market. The motivation to seek
new products and processes is driven by the expectation of new profit opportunities.
An entrepreneur is an initiator, innovator, and risk bearer—the catalyst who combines,
land, labor and capital resources in new and unique ways to produce new goods and
services. Historically, these were individuals. In today’s more technologically complex
economy, this role is just as likely to be carried out by entrepreneurial teams. Unlike
entrepreneurs, other innovators do not bear personal financial risk. These people include
key executives, scientists, and other salaried employees engaged in commercial R&D
activities.
New scientific knowledge is highly important to technological advance, but scientific
principles, as such, cannot be patented. For this reason entrepreneurs actively study the
scientific output of university and government laboratories to find discoveries with
commercial applications, obtaining information without paying for its development.
Although, firms increasingly help fund university research that relates to their products,
scientists increasingly realize their work may have commercial value.
4. Consider the effect that corporate profit taxes have on investing. Look back at Figure 11W.4.
Suppose that the r line is the rate of return a firm earns before taxes. If corporate profit taxes are
imposed, the firm’s after‐tax returns will be lower (and the higher the tax rate, the lower the after‐
tax returns). If the firm’s decisions about R&D spending are based on comparing after‐tax returns
with the interest‐rate costs of funds, how will increased corporate profit taxes affect R&D
spending? Does this effect modify your views on corporate profit taxes? Discuss. LO3
11W-2
whole or part.
Answer:
If corporate profit taxes are imposed on the firm this will reduce the after tax return at
each level of investment. This will cause the expected rate of return schedule (after tax
return) to shift left reducing investment.
For example, if the tax rate is 50% the firm only keeps 50% of the before tax return. In
the diagram above the equilibrium level of R&D expenditure (investment) is $60 million
at an interest rate and before tax rate of return of 8%. However, with a tax rate of 50% the
firm only keeps half of the 8% return, which equals 4%. Thus, this is no longer the
equilibrium because the firm's after tax return of 4% is less than the 8% interest rate.
11W-3
whole or part.
The firm will reduce investment until the after tax rate of return equals the interest rate of
8%. This occurs at the investment level of $20 million. The before tax rate of return
equals 16% and the after tax rate of return equals 8% (which equals the interest rate).
In conclusion the implementation (or increase) in the corporate profit tax will reduce
R&D expenditure because the firm considers the after tax return, not the before tax
return, when undertaking investment projects since this is what determines the
profitability.
This will likely cause the student to modify their views about corporate profit taxes if
they originally thought they should be higher. However, they may not change their
beliefs if they are considering equality and distribution issues.
5. Answer the following lettered questions on the basis of the information in this table: LO3
a. If the interest‐rate cost of funds is 8 percent, what will be the optimal amount of R&D spending
for this firm?
b. Explain why $20 million of R&D spending will not be optimal.
c. Why won’t $60 million be optimal either?
Answer:
(a) $50 million, where the interest-rate cost of funds equals the expected rate of return.
(b) at $20 million in R&D, the expected rate of return of 14 percent exceeds the interest-
rate cost of funds of 8 percent, thus there would be an underallocation of R&D funds;
(c) at $60 million, the expected rate of return of 6 percent is less than the interest-rate
cost of funds of 8 percent, thus there would be an overallocation of R&D funds.
6. Explain: “The success of a new product depends not only on its marginal utility but also on its
price.” LO3
Answer: A new product may have a high level of marginal utility per unit consumed.
However, if this product also has a high price the marginal utility per dollar may still be
low.
For example, assume that you are already consuming good A. The marginal utility of the
last unit consumed is 6 and price of the good is $2. The marginal utility per dollar for
good A (last unit consumed) equals 3 (=6/$2).
Now assume a different firm comes out with a new good B. The marginal utility for first
unit consumed of good B equals 100 and the price is $50. The marginal utility per dollar
for good B (last unit consumed) equals 2 (=100/$50).
11W-4
whole or part.
Given the choice of consuming good A or switching to a unit of good B the consumer
will choose to continue to purchase good A and NOT to consume good B even though the
marginal utility is higher. Individuals compare marginal utility per dollar not the marginal
utility alone when making consumption choices.
The same logic applies to the case where the price is low for the product and marginal
utility is low as well.
7. Learning how to use software takes time. So once customers have learned to use a particular
software package, it is easier to sell them software upgrades than to convince them to switch to
new software. What implications does this have for expected rates of return on R&D spending for
software firms developing upgrades versus firms developing imitative products? LO4
Answer: Expenditures on R&D carry a great deal of risk. Upgrading an existing product
is likely to be less risky than developing an imitated product. Consumers value their time
as well as money and are likely to prefer products that are familiar.
Imitating a successful product may save the cost of R&D for development, but there are
significant protections that may end up costing the “copy cat” firm dearly. Patents,
copyrights and brand name recognition all contribute to give the original innovator a
major marketing advantage.
8. Why might a firm making a large economic profit from its existing product employ a fast‐
second strategy in relationship to new or improved products? What risks does it run in pursuing
this strategy? What incentive does a firm have to engage in R&D when rivals can imitate its new
product? LO4
Answer: A dominant firm that is making large profits from its existing products may let
smaller firms in the industry incur the high costs of product innovation while it closely
monitors their successes and failures. In using this “fast, second strategy,” the dominant
firm counts on its own product improvement abilities, marketing prowess, or economies
of scale to prevail.
A firm that attempts to imitate the new products of rival firms may encounter a variety of
roadblocks. Patent rights for a secret process may stop the effort cold or lead to costly
lawsuits.
Developing new products can be very profitable and there are several protections, and
advantages to taking the lead including: patent protection, copyrights and trademarks,
lasting brand name recognition, benefits from trade secrets and learning by doing, high
economic profits during the lag time between a product's introduction and its imitation,
and the possibility of lucrative buyout offers from larger firms’.
11W-5
whole or part.
9. Do you think the overall level of R&D would increase or decrease over the next 20 to 30 years
if the lengths of new patents were extended from 20 years to, say, “forever”? What if the duration
were reduced from 20 years to, say, 3 years? LO4
Answer: If patent rights were extended indefinitely the motivation to spend on R&D
could increase for two reasons. First the extended patent rights would add to their
potential value and second, perpetual patent rights would provide an additional incentive
to find a way around these rights. Firms would be motivated to seek other products and
processes not covered by the endless patent restrictions.
If the restriction were reduced to a much shorter period of three years, the spending on
R&D would be likely to decrease. The short period of protection would make it difficult
to recover the costs of development.
10. Make a case that neither pure competition nor pure monopoly is conducive to a great deal of
R&D spending and innovation. Why might oligopoly be more favorable to R&D spending and
innovation than either pure competition or pure monopoly? What is the inverted‐U theory of
R&D, and how does it relate to your answers to these questions? LO5
Answer: For a purely competitive firm, the expected rate of return on R&D may be low
or even negative. Because of easy entry, its profit rewards from innovation may quickly
be competed away by existing or entering firms that also produce the new product or
adopt the new technology. The small size of the firm would make it difficult to finance
the R&D as well.
The pure monopoly market structure may provide the least incentive to engage in R&D.
Absolute barriers prevent competition. The only incentive for R&D expenditures would
be defensive, to reduce the risk of some new product or process that could destroy the
monopoly.
The oligopoly market structure has many characteristics that are conducive to
technological advance. First, the large size enables them to finance the often very
expensive R&D costs associated with major product or process innovation. The typical
firm in oligopoly is likely to realize ongoing economic profits, which provides a ready
source of funds. The existence of barriers to entry gives some assurance that any
economic profits earned from innovation can be maintained. The large volume of sales
allows the firm to spread the cost of R&D over a great many units of output. The large
size of the firms in oligopoly also makes it easier to absorb the inevitable losses from
“misses” while waiting for compensation from the “hits.”
The inverted-U theory suggests that R&D expenditures as a percentage of sales rise with
industry concentration until the four-firm concentration ratio reaches about 50%. Further
increases in industry concentrations are associated with lower relative R&D expenditures.
(See figure 11W-7) The inverted-U theory reiterates the assessment made above
regarding likely R&D spending and market structure.
11W-6
whole or part.
11. Evaluate: “Society does not need laws outlawing monopolization and monopoly. Inevitably,
monopoly causes its own self‐destruction since its high profit is the lure for other firms or
entrepreneurs to develop substitute products.” LO6
Answer: Innovation can reduce or even disintegrate existing monopoly power by

producing competition where there was none. According to Schumpeter, a new innovator
will automatically displace any monopolist that no longer delivers superior performance.
But many contemporary economists think this view reflects more wishful thinking than
fact. Dominant firms have been known to persuade government to give them tax breaks,
subsidies, and tariff protection to strengthen their market power. While innovation in
general enhances economic efficiency, in some cases it can lead to entrenched monopoly
power. Further innovation may eventually destroy this monopoly power, but the process
of creative destruction is neither automatic nor inevitable.
12. LAST WORD Identify a specific example of each of the following in this chapter’s Last
Word: (a) entrepreneurship, (b) invention, (c) innovation, and (d) diffusion.
Answer:
(a) 1985- Ted Waitt starts a mail-order personal computer business (Gateway 2000) in
his South Dakota barn.
(b) 1947- AT&T scientists invent the “transfer resistance device” later known as the
transistor. It replaces the less reliable vacuum tubes in computers.
(c) 1981- Logitech commercializes the “x-y position indicator for a display system.”
Invented earlier by Douglas Engelbart in a government funded research lab.
Someone dubs it a “computer mouse” because it appears to have a tail.
(d) 1982- Compaq Computer “clones” the IBM machines; others do the same.
Eventually Compaq becomes the leading seller of personal computers.
PROBLEMS
1. Suppose a firm expects that a $20 million expenditure on R&D this year will result in a new
product that will increase its profit next year by $1 million. LO3
a. What is the expected rate of return on this R&D expenditure?
b. Suppose the firm can get a bank loan at 6 percent interest to finance its $20 million R&D
project. Will the firm undertake the project?
c. Now suppose the interest‐rate cost of borrowing, in effect, falls to 4 percent because the firm
decides to use its own retained earnings to finance the R&D. Will this lower interest rate change
the firm’s R&D decision?
d. Now suppose that the firm has savings of $20 million—enough money to fund the R&D
expenditure without borrowing. If the firm has the chance to invest this money either in the R&D
project or in government bonds that pay 3.5 percent per year, which should it do?
e. What if the government bonds were paying 6.5 percent per year?
Answers: (a) 0.05; (b) No; (c) Yes; (d) Invest in R&D; (e) Invest in bonds.
Feedback: Consider the following example. Suppose a firm expects that a $20 million
expenditure on R&D this year will result in a new product that will increase its profit next
year by $1 million.
11W-7
whole or part.
a. What is the expected rate of return on this R&D expenditure?

The expected rate of return equals the (expected) profit from the R&D divided by the
expenditure.
Expected rate of return = profit/expenditure = $1/$20 = 0.05 (or 5% = 0.05x100)
b. Suppose the firm can get a bank loan at 6 percent interest to finance its $20 million
R&D project. Will the firm undertake the project?
The firm will not borrow at a rate greater than the expected rate of return. Since the bank
loan has a 6% rate of interest, which exceeds the expected rate of return, the firm will not
undertake this project.
c. Now suppose the interest‐rate cost of borrowing, in effect, falls to 4 percent because
the firm decides to use its own retained earnings to finance the R&D. Will this lower
interest rate change the firm’s R&D decision?
The firm will borrow at a rate less than the expected rate of return. Since the bank loan
now has a 4% rate of interest, which is less than the expected rate of return, the firm will
undertake this project.
d. Now suppose that the firm has savings of $20 million—enough money to fund the
R&D expenditure without borrowing. If the firm has the chance to invest this money
either in the R&D project or in government bonds that pay 3.5 percent per year, which
should it do?
The firm will invest its savings where the return is the highest. Since government bonds
pay 3.5% per year and the expected rate of return on the R&D project is 5%, the firm
should invest in the R&D project.
e. What if the government bonds were paying 6.5 percent per year?
If government bonds pay 6.5% per year and the expected rate of return on the R&D
project is 5%, the firm should invest in government bonds (not undertake the project).
2. A firm faces the following costs. Its total cost of capital = $1000; its price paid for labor = $12
per labor unit; and its price paid for raw materials = $4 per raw‐material unit. LO3
a. Suppose the firm can produce 5000 units of output this year by combining its fixed capital with
100 units of labor and 450 units of raw materials. What are the total cost and average total cost of
producing the 5000 units of output?
b. Now assume the firm improves its production process so that it can produce 6000 units of
output this year by combining its fixed capital with 100 units of labor and 450 units of raw
materials. What are the total cost and average total cost of producing the 6000 units of output?
c. If units of output can always be sold for $1 each, then by how much does the firm’s profit
increase after it improves its production process?
d. Suppose that implementing the improved production process would require a one-time-only
cost of $1100. If the firm only considers this year’s profit, would the firm implement the
improved production process? What if the firm considers its profit not just this year but in future
years as well?
Answers: (a) The TC = $4,000 so that the ATC = $0.80.

(b) The TC is unchanged at $4,000, but ATC = $0.67.
11W-8
whole or part.
(c) Profits are $1000 higher.

(d) No; Yes.
Feedback: Consider the following example. A firm faces the following costs. Its total
cost of capital = $1000; its price paid for labor = $12 per labor unit; and its price paid for
raw materials = $4 per raw‐material unit.
a. Suppose the firm can produce 5000 units of output this year by combining its fixed
capital with 100 units of labor and 450 units of raw materials. What are the total cost and
average total cost of producing the 5000 units of output?
Total cost equals the total cost of capital plus the total cost of labor (price per labor unit x
units of labor) plus the total cost of raw materials (price per raw material unit x units of
raw material).
Total cost = $1000 + $1200 ($12 x 100) + $1800 ($4 x 450) = $4000
Average total cost equals the total cost divided by the number of units produced.
Average total cost = $4000/5000 = $0.80 per unit
b. Now assume the firm improves its production process so that it can produce 6000 units
of output this year by combining its fixed capital with 100 units of labor and 450 units of
raw materials. What are the total cost and average cost of producing the 6000 units of
output?
The total cost does not change after the improvement in the production process.
Total cost = $1000 + $1200 ($12 x 100) + $1800 ($4 x 450) = $4000
However, since the firm can produce more units with the same amount of inputs the
average total cost will fall.
Average total cost = $4000/6000 = $0.67 per unit
c. If units of output can always be sold for $1 each, then by how much does the firm’s
profit increase after it improves its production process?
The firm's profit equals total revenue (price x units produced and sold) minus total cost.
Prior to the improvement of the production process: profit = $5000 - $4000 = $1000
After to the improvement of the production process: profit = $6000 - $4000 = $2000
Thus, the change (increase) in profits after the improvement of the production process
equals $1000 (= $6000 - $5000).
d. Suppose that implementing the improved production process would require a one-time-
only cost of $1100. If the firm only considers this year’s profit, would the firm
implement the improved production process? What if the firm considers its profit not just
this year but in future years as well?
If the firm only considers this year’s profit, the firm would choose not to implement the
improved production process. The firm will only increase profit by $1000 for the year,
which is less than the $1100 one-time-only cost.
If the firm considers its profit not just this year, but in future years as well, it will
implement the improved production process under any reasonable scenario. The firm will
earn $1000 for the life of the project (every year) and it will only have a one-time-only
cost of $1100. Even after two years the profit generated will exceed the cost unless the
discount rate (interest rate) is excessively high.
11W-9
whole or part.

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Chapter 11W - Technology, R&D, and Efficiency

Chapter 11W Technology, R&D, and Efficiency

Answer: Innovation can reduce or even disintegrate existing monopoly power by

a. What is the expected rate of return on this R&D expenditure?

Answers: (a) The TC = $4,000 so that the ATC = $0.80.

(c) Profits are $1000 higher.

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