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13 Microeconomics of “The New Economy”: Innovation and Growth The Bourgeoisie [I.e., capitalism] cannot exist without constantly revolutionizing the instruments of production. . . . The bourgeoisie, during its rule of scare one hundred years has created more massive and more colossal productive forces than have all preceding generations together. KARL MARX AND FRIEDRICH ENGELS, THE COMMUNIST MANIFESTO, 1847 Contents ● The Free Market’s Incredible Growth Record ● What’s New about the New Economy? ● The Firm and Innovation ● Three Growth-Creating Properties of Innovation ● Do Free Markets Spend Enough on R&D Activities? ● Conclusion: The New Economy and the Innovation Assembly Line Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Free Market’s Incredible Growth Record ● Since the Industrial Revolution the growth in per-capita income and productivity in free-market economies has been enormous compared to the 1,500 years before the Industrial Revolution. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Free Market’s Incredible Growth Record ● Innovation-♦ the process by which new products or new methods of production are introduced, including all the steps from the inventor’s idea to bringing the new item to market. ♦ permitted growing outputs that enabled society to invest increasingly in productive plant and equipment and in education. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Free Market’s Incredible Growth Record ● Labor productivity = the amount of output a worker turns out in an hour (or a week or a year) of labor ● Over the long run, productivity growth is what counts most in raising living standards. ● Rapid innovation has been a constant feature of the modern industrial era. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 13-2 Declining Real Labor Price, Electronic Products Hours of Work Time Needed to Purchase Items FIGURE 2,467 2,500 2,000 1,500 1,000 562 500 0 494 365 23 Color TV 1954/1997 15 VCR 1972/1997 57 42 456 0.76 Home Calculating movie device camera 1916/1997 1960/1997 15 Microwave oven 1947/1997 9 Cellular phone 1984/1997 Copyright© 2003 South-Western/Thomson Learning. All rights reserved. What’s New about the New Economy? ● Real expenditures on R&D by U.S. firms rose rapidly from 1970-1998. ● New innovations disseminated more rapidly. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 13-4 Increasing Real Expenditures on R&D FIGURE $140,000 Millions of 1992 Dollars 120,000 100,000 80,000 60,000 40,000 20,000 0 1970 1975 1980 1985 1990 1995 1998 Year Copyright© 2003 South-Western/Thomson Learning. All rights reserved. What’s New about the New Economy? ● Growth in Spending on Innovation and Speeding Up of Dissemination ♦ Any firm that can come up with a better model than rivals gains an advantage that its competitors cannot match as quickly and easily as a price cut. ♦ Research and development (R&D) is the means by which firms create new products and prepare them for market. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What’s New about the New Economy? ● Growth in Spending on Innovation and Speeding Up of Dissemination ♦ Firms in “innovation arms race” – firms must innovate in order to compete with rivals. ♦ Many firms must spend large sums on R&D to develop products that have low marginal costs. ♦ Firms cannot follow marginal cost pricing rule (P = MC) as it will not allow them to recover R&D costs. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What’s New about the New Economy? ● Externality = incidental benefits or damages of an activity that affect others not directly involved in the activity. ● Network Externality = entry of an additional participant into a group of connected individuals or organizations benefits the initial members of a group. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What’s New about the New Economy? ● Good Collusion Versus Bad Collusion ♦ Design Compatibility = different network components must be designed to work together. ♦ Gives rise to need for “good collusion” among firms to maximize benefits of new innovations. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. What’s New about the New Economy? ● Globalization ♦ Globalization aided by speed of travel, competition from foreign sources, new communication technologies. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The Firm and Innovation ● If the firm seeks to maximize its profits, it will expand its spending on R&D up to the point at which its anticipated marginal cost of R&D equals its anticipated marginal revenue from R&D Copyright© 2003 Southwestern/Thomson Learning All rights reserved. How Much Will a Profit-Max. Firm Spend on Innovation? ● Perfectly competitive industries permit firms to earn just what they need to pay investors for the funds they provide. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. How Much Will a Profit-Max. Firm Spend on Innovation? ● Due to barriers to entry for innovation, we cannot be certain that economic profits to invention will tend exactly toward zero, but we can still expect them to be very low on average. ● While inventive activity sometimes pays off enormously well, large R&D investments also can fail spectacularly, so that the average comes out close to zero. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Profits of Innovation ● Since only a small percentage of new products ever make it all the way to the marketing stage, we would expect firms to minimize their risks. ● One way firms try to protect themselves is by joining together in “research joint ventures” to share risks. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Profits of Innovation ● Another arrangement is technology trading in which a firm voluntarily makes its privately owned technology available to other firms either in exchange for access to the technology of the second company, or on payment of an agreed-upon fee. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Profits of Innovation ● Many firms and industries engage in the practice of cross licensing where each of two firms agrees to let the other use some specified set of its patents, either at a price specified in their agreement or in return for access to the other firm’s patents. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. A Kinked Revenue Curve Model of Spending on Innovation ● Why do firms innovate? ♦ Expensive and risky ♦ Expected economic profits approach zero ♦ If firms do not keep up with competitors in terms of product attractiveness and improved process efficiency that lowers costs, they will lose out to their rivals and end up losing money. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. A Kinked Revenue Curve Model of Spending on Innovation ● An asymmetry in the firm’s expectations about its competitors helps explain spending on innovation. ♦ A firm expects mixed reactions from its competitors: they will follow its lead in increasing R&D, but will not follow any decreases. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 13-6 Competition and R&D Investment FIGURE R&D Spending not Matched M S C R MC MR and MC B m A r R&D Spending Matched 0 7 20 R&D Investment in Millions of Dollars Copyright© 2003 South-Western/Thomson Learning. All rights reserved. A Kinked Revenue Curve Model of Spending on Innovation ● All firms in an industry continue to invest same amount until one has research breakthrough leading to a new product. ● Firm then expands its investment in the breakthrough product, because doing so will pay off even if the other firms in the industry match the increase. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. A Kinked Revenue Curve Model of Spending on Innovation ● This process, described as a ratchet, assumes that competition forces firms in the industry to keep up with one another in their R&D investment. ● Once caught up, investment level remains fairly level until one firm increases its spending, and all other firms follow behind. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. A Kinked Revenue Curve Model of Spending on Innovation ● This arrangement holds technological spending steady, permits it under certain circumstances to move forward, but generally does not allow it to retreat. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 13-7 Competition and R&D Investment FIGURE M2 M1 C MR and MC MC B2 B1 R2 A 0 20 R1 25 R&D Investment in Millions of Dollars Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Three Growth-Creating Properties of Innovation ● Many innovations create cumulative changes. ● Technical knowledge has a public good property. ● Innovations enjoy an accelerator feature. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Three Growth-Creating Properties of Innovation ● Cumulative Innovation ♦ The economy’s stock of technical knowledge keeps expanding as new information is added to old. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Three Growth-Creating Properties of Innovation ● The Public Good Property of Innovation ♦ Technical knowledge can be used over and over again without ever being depleted. ♦ A process innovation changes the way in which a commodity is produced. ♦ A product innovation introduces a good or service that is entirely new or involves major modifications of earlier products. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Three Growth-Creating Properties of Innovation ● The Accelerator Property of Innovation ♦ Successful innovation adds to nation’s GDP ■firms create more products with given resources ■makes new and more valuable products available ♦ Thus when R&D produces a steady output of innovations, GDP is higher each year. ♦ Cost-cutting process innovation ■increases output ■decreases the price Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 13-8 Higher R&D Spending Accel. GDP Growth FIGURE Y2 R&D Spending and GDP Y1 R2 R1 2000 2025 2050 2075 2100 2125 Year Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 13-9 Effect of Process Innovations on Prices & Outputs FIGURE D P1 P2 MC1 MC2 Price E1 E2 D (AR) MR 0 Q1 Q2 Quantity of Widgets Produced Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Do Free Markets Spend Enough on R&D Activities? ● As with any investment, R&D investment entails a trade-off between present and future. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Do Free Markets Spend Enough on R&D Activities? ● Innovation as a Beneficial Externality ♦ Because the acquisition of new technical knowledge generates large beneficial externalities, private enterprise may not devote enough resources to innovation. ♦ Basic research refers to research that seeks to provide scientific knowledge and general principles rather than coming up with any specific marketable inventions. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Do Free Markets Spend Enough on R&D Activities? ● Innovation as a Beneficial Externality ♦ Applied research is research whose goal is to invent or improve particular products or processes. ♦ The externality problem is probably most severe for basic research. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Do Free Markets Spend Enough on R&D Activities? ● Innovation as a Beneficial Externality ♦ Because of the externality problem, the governments of the United States and a number of other industrial countries provide money to finance basic research. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Do Free Markets Spend Enough on R&D Activities? ● Why the Shortfall in Innovation Spending May Not Be So Big After All ♦ Technology Trading = firm makes technology available to others in exchange for access to the other firms’ technologies or for fees. ■Allows greater profits to innovators, hence expands innovation. ♦ Cross-Licensing = occurs when each of two firms agree to let the other use their patents, either for a fee or in a swap Copyright© 2003 Southwestern/Thomson Learning All rights reserved. The New Economy and the Innovation Assembly Line ● More effective and fierce competition ● New problems for prevention or control of monopoly ● More rapid resource depletion but also way to use natural resources more efficiently ● Left many economic problems unsolved but raised standards of living and accelerated the rate of improvement in wealthiest countries Copyright© 2003 Southwestern/Thomson Learning All rights reserved.