THEORY OF ECN410 Economics of

INNOVATING FIRM Innovation & Technology

MARKET STRUCTURE AND
INCENTIVES TO INNOVATE
We will explore the two-way relationship
between market structure and firms’ (profit)
incentives to innovate
How do firms’ incentives to invest in R&D depend on
the product market structure they are in?
How may firms use R&D to shape the structure of their
market?
TYPES OF INNOVATION
There are two major types of innovation that
can be modelled
Product Innovation: introduction of a new product
(demand creation)
Process Innovation: introduction of a new production
process (cost reduction)
Drastic (major) innovation: a process innovation that
reduces costs so much that the innovating firm behaves like a
monopoly without price constraint
Nondrastic (minor) innovation: a process innovation that
gives the innovating firm some cost advantage, but the firm is
still constrained by price competition
We will focus on process innovation
 PROCESS INNOVATION
Assume the market has a number of firms producing homogeneous products
at constant marginal cost MC0 and compete in prices. Some firm discovers a
process innovation that reduces MC of production.

P P Nondrastic Process Innovation

Drastic Process Innovation

MC0 MC0

MCN
D

MC
D
M D M D
Q0 R Q Q0 R Q
MARKET STRUCTURE AND
INCENTIVES TO INNOVATE
How much is a firm willing to pay for a
nondrastic (minor) process innovation that it can
use exclusively for unlimited time?
Willingness to pay for innovation can be measured by
the increase in profits the innovation generates.
We will compare the response between a competitive
firm and a monopoly firm.
 COMPETITIVE FIRM’S
INCENTIVE TO INNOVATE
Assume the process innovation
is nondrastic.
P
Prior to innovation, Q0 is sold at
P = MC0 and all firms make zero
profit.
Pm  The firm that obtains the
MC0 technology produces at MC1 and
charges P slightly less than MC0
It cannot charge Pm
MC1
The firm’s profit from
innovation is Q0(MC0 – MC1)
M D
Qm Q0 R
Q
 MONOPOLY FIRM’S INCENTIVE
TO INNOVATE
Assume the process innovation is nondrastic
and the monopoly firm faces no threat of
P entry.
Prior to innovation, QM is sold at PM and the
firm’s profit is QM(PM – MC0) =
PM
 After innovation, QM’ is sold at PM’ and the
PM’ firm’s profit is QM’(PM’ – MC1) =
MC0
The firm’s profit from innovation is

MC1

M D
QM QM’ R
Q
 COMPARING COMPETITIVE FIRM’S AND
MONOPOLY FIRM’S INCENTIVE TO INNOVATE
Profit from a nondrastic process innovation is
larger for a competitive firm than for a
monopoly firm.
P This is known as the Replacement Effect: A
competitive firm places a larger value on a
minor process innovation than a monopoly
PM firm.
The innovation creates brand new profit opportunity for
PM’ the competitive firm, which earns zero profit prior to
innovation.
MC0
The innovation simply ‘replaces’ existing profit for the
monopoly firm with a larger one.

Example: Microsoft Xbox

MC1 Microsoft is not as innovative in its core business
(Windows OS, MS Office) as in the gaming and cloud
computing markets.

M D
QM QM’ Q0 R
Q
Exercise: Suppose the inverse market demand for a product is p = 50 – 0.5Q. Firms
produce at a constant MC = 30. A minor process innovation will reduce MC to 20.
a) Find the profit from innovation if a competitive firm invests in the innovation.
b) Find the innovation profit if a monopoly firm invest in the innovation.
INCENTIVES TO INNOVATE
FOR OLIGOPOLY FIRMS
The incentives to innovate for oligopolistic firms are
affected by the intensity of competition, which can
depend on
Number of firms in the market
Degree of product differentiation
Type of competition
Price (Bertrand) competition
Quantity (Cournot) competition

In general, incentives to innovate in oligopoly markets

are non-monotonic
INCENTIVES TO INNOVATE
FOR OLIGOPOLY FIRMS
We will simplify the discussion by analyzing a
simple Cournot oligopoly market with n firms
producing homogeneous product.
Assume linear market demand and linear cost function ,
where ci is the marginal cost
It can be shown the Cournot equilibrium profit for
firm i is
Assume prior to the minor process innovation, all firms
produce at ci = c0, and after innovation the innovating firm
reduces its MC to c1 < c0. The innovating firm’s
Profit before innovation is
Profit after innovation is
INCENTIVES TO INNOVATE
FOR OLIGOPOLY FIRMS
Profit from innovation is

c0 – c1 measures the absolute size of innovation (size of

cost reduction)
a – c0 measures the size of the initial market (difference
between highest willingness to pay and pre-innovation
marginal cost)
Let s = a – c0 and define as the relative size of
innovation. We can rewrite profit from innovation as
INCENTIVES TO INNOVATE
FOR OLIGOPOLY FIRMS
Profit from innovation is where
s = a – c0 is the size of the initial market
 is the relative size of innovation.

Effect of number of firms (a measure of competition

intensity) on profit from innovation is

Profit from innovation may follow an inverse U-shape as the

number of firms increases
An increase in the number of firms raises the profit incentive
to innovate if the relative size of innovation () is large enough:
Exercise: Suppose in a Cournot oligopoly market with n firms, the inverse market demand
is p = 50 – 0.5Q. Each firm initially produces at a constant MC = 30.
a) If a firm invests in R&D that reduces its MC to 20, find the firm’s profit from the
innovation as a function of number of firms in the market.
b) If a firm invests in R&D that reduces its MC to 15, find the firm’s profit from the
innovation as a function of number of firms in the market.
https://www.desmos.com/calculator
EFFECT OF INNOVATION
ON MARKET STRUCTURE
We will consider the case where a monopoly firm is threatened
by entry.
Both the incumbent and entrant firms can acquire a nondrastic process
innovation, which reduce MC from c0 to c1.
Assume the entrant firm can only profit by innovating
If the incumbent obtains the innovation, the entrant stays out and
earns zero profit. The incumbent makes monopoly profit Πm(c1)
If the entrant obtains the innovation, the market structure
becomes a duopoly. The entrant will have a cost advantage and
makes duopoly profit Πd(c1).
The incumbent will have a cost disadvantage and makes duopoly profit
Πd(c0).
EFFECT OF INNOVATION
ON MARKET STRUCTURE
Incentive to innovate for
Incumbent: VI = Πm(c1) - Πd(c0)
Entrant: VE = Πd(c1) - 0
Incumbent firm will have higher incentive to
innovate if VI > VE or Πm(c1) > Πd(c0) + Πd(c1)
This condition is met if the products sold by the two firms are
close substitutes.
A monopoly threatened by entry is willing to pay more for a
minor innovation than a potential entrant who produces a close
substitute product.
EFFECT OF INNOVATION
ON MARKET STRUCTURE
Efficiency Effect: fear of losing its monopoly
position provides the incumbent firm with strong
incentive to innovate and prolong its monopoly
position.
Examples:
Strategic use of unused (dormant) patents by dominant firms to block
potential entries into their markets
‘Pay-for-delay’ agreement in which brand-name drug makers pay
generic drug makers to delay the launch of cheaper versions of their
drug.
Exercise: Suppose a monopoly firm faces the following inverse market demand p = 50 – 0.5Q.
The monopoly firm produces at a constant MC = 30. A cost-reducing technology is available
that will reduce MC to 20. The monopoly firm competes with a potential entrant to obtain the
technology. If the entrant gets the technology, the market becomes duopoly and the entrant
gets to produce at MC = 20 and the incumbent produces at MC = 30. If the incumbent obtains
the technology, it remains a monopoly and produces at MC = 20 while the entrant stays out and
makes zero profit.
a) Find the profit incentive to innovate for the entrant firm.
b) Find the profit incentive to innovate for the incumbent firm.
EFFECT OF INNOVATION ON
MARKET STRUCTURE
Firms also need to decide about the intensity and timing
of their R&D investments with the goal of being the first to
come up with an innovation (patent race).
When time and uncertainty are factored in, it is in
general ambiguous whether the incumbent or the entrant
has a stronger incentive to invest in R&D.
Outcome depends on balance between
Efficiency effect  higher incentives for incumbent to innovate
Net profit flows the incumbent receives by preempting the entrant is larger
than what the entrant gets by being first
Replacement effect  lower incentives for incumbent to innovate
Marginal productivity of R&D expenditure for the incumbent is lower if its
initial monopoly profit is higher.
If the incumbent spends more on R&D, it would hasten its own replacement.
INNOVATION STRATEGIES
OF THE FIRM
As alternatives to the theory of strategic innovation by
rational profit-maximizing firms, we will consider 6
‘narrative’ innovation strategies proposed by Mokyr
(1997)
Profit-maximization is difficult to achieve when there are
uncertainties
Market equilibrium may be more of an exception rather than the
norm, especially in highly strategic interactive environments.
Historical experiences of how firms react to technical changes
can be informative.
INNOVATION STRATEGIES
OF THE FIRM
Offensive strategy
The goal is to achieve innovative leadership by introducing new
products ahead of competitors
Highly research intensive and rely heavily on inhouse R&D
Place high value on patent protection and monopoly position
Willing to take risks and long-term R&D investment view
Require strong coordination between R&D, production, and
marketing personnel
Examples: Color TV (RCA), Corfam (Du Pont), PVC (IG
Farben), transistors (Bell Lab), Tesla’s electric cars
INNOVATION STRATEGIES
OF THE FIRM
Defensive strategy
Can be as research-intensive as offensive strategy but differ in the nature
and timing of innovations
Unwilling to take on the risks of being the first to innovate, but not
wanting to be the last and left out either
May wait to profit from the mistakes of early innovators or from the new
markets early innovators created
Need to maintain enough innovative capacity to quickly move up when timing is right
Typical of most oligopolistic markets and closely related to product
differentiation
Examples: IBM, European semiconductor industry, electric cars made by
major auto companies
INNOVATION STRATEGIES
OF THE FIRM
Imitative strategy
Follow the leaders in established technologies with some time lag
May exploit expired patents or purchase secondary patents or license to keep
up with know-how
Does not spend heavily on R&D
Enjoy certain advantage to compete with established innovating firms
Captive market (often through govt tariff protection – import substitution strategy or
infant industry argument)
Lower costs (labor, material, energy, production, managerial overhead cost from
lower R&D spending and training)
May turn into ‘latecomer advantage’ where the imitator can compete with
early innovators
Examples: Japanese semiconductor industry, South Korean steel industry,
Chinese IT/e-commerce industry (Alibaba, Tencent, Huawei)
INNOVATION STRATEGIES
OF THE FIRM
Dependent strategy
Takes a subordinate role in relation to other stronger innovative firms
Does not attempt to initiate or imitate technical changes
Innovative activities center around meeting or improving technical
requests from its customers or parent company
Often rely on technical specification and advice from customer or parent company
OEM/ODM manufacturing
Subcontractor or sub-subcontractor
Typically has no R&D
Accumulation of technical know-hows or customer base overtime may
propel some dependent firms to take on more offensive strategies in
niche markets
Examples: Satellite firms of large multinational corporations, Foxconn
INNOVATION STRATEGIES
OF THE FIRM
Traditional strategy
Product supplied by traditional firm changes little or not at all
Has no scientific and technical capacity to initiate significant
product changes
Technical changes are cosmetic and lack technical substance
Technical inputs often depend on craft skills
Lack defense against ‘creative destruction’ and are gradually
driven out over time
Examples: handicraft makers, cereal companies
INNOVATION STRATEGIES
OF THE FIRM
Opportunist strategy
Identify and exploit niche markets created in rapidly changing
environment without having to spend heavily on inhouse R&D
to deliver products or services consumers need
Require imaginative entrepreneurial insights to see
opportunities that others do not see
Examples: Lefty’s, Sparkcharge (Joshua Aviv)