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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.
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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.
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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.
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What’s New about the New
Economy?
● Globalization
♦ Globalization aided by speed of travel,
competition from foreign sources, new
communication technologies.
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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.
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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.
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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.
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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
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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.
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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.
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Three Growth-Creating
Properties of Innovation
● Cumulative Innovation
♦ The economy’s stock of technical knowledge
keeps expanding as new information is added
to old.
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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
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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
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Do Free Markets Spend
Enough on R&D Activities?
● As with any investment, R&D investment
entails a trade-off between present and
future.
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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.
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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.
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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.
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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
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