chapter 11
Technology, R&D, and Efficiency

CHAPTER OVERVIEW

This chapter introduces students to the importance of technical advances, R&D decisions, and innovation and brings these topics directly into the core microeconomic chapters.  This chapter focuses explicitly on the effects of market structure on technological progressiveness.
We believe that R&D and innovation are simply too important to student understanding of modern industrial economies to disregard or relegate to a side bar.  Therefore, we have integrated this material into the main flow of the theory of the firm.  The instructor, however, can bypass this chapter without jeopardizing course continuity.

WHAT’S NEW

Most of the changes in this chapter consist of updated numbers and examples. There is a new section on technological advance and the efficiency of health care delivery in Canada. The Last Word now includes the top 10 internet markets, including Canada. The section on consumer surplus and producer surplus has been deleted from this chapter and placed in Chapters 6, 8 and 9.
A “Consider This” box has been added dealing with the board game Monopoly as an interesting example of a patented trademarked product that is still earning a substantial profit after many decades.  It appeared on the website in the previous edition as an “Analogies, Anecdotes, and Insights” piece.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to understand:

1. The distinction between invention, innovation, and technological diffusion.
2. About the role of entrepreneurs and other innovators.
3. A firm’s optimal amount of R&D.
4. About the role of market structure on technological change.
5. How technological advance enhances both productive and allocative efficiency.

COMMENTS AND TEACHING SUGGESTIONS

1. Student interest in this topic is likely to be high.  Oral reports presenting recent newspaper or magazine articles on inventions, innovations or projections of new products, new materials or new processes should spark good discussion.  Scientific American frequently devotes an issue to new technologies within a specific industry.  In addition, Discover, Popular Science, weekly news magazines, and the National Post and the Globe and Mail are all likely to feature reports on new technology. 
2. Many craftsmen are natural innovators.  Have the students interview someone that works in the building trades (carpenters, tile setters, plumbers, or welders).  Each construction job is different and often special problems or conditions make doing the job a challenge.  Many craftsmen have developed their own unique methods and are proud of both their efficient systems and the appearance of the finished projects.  In some cases, this assignment could bring new appreciation for a parent or other family member who operates a business.
3. Ask students to describe an incident when they were faced with a task to complete without the proper or most convenient tools.  How did they solve the problem?  Did they fashion a new tool or use a tool designed for another purpose creatively?

LECTURE NOTES

I.          Technological Advance:  Invention, innovation and diffusion.
A.  In the short run it is assumed that technology, plant, and equipment are constant.  In the long run, the size of the plant can change and firms can enter or leave the industry; in the very long run, technological advances can occur.
B.   Technological advance is a three-step process that shifts the economy’s production possibilities curve outward-enabling more production of goods and services.
1.   The most basic element of technological advance is invention:  The discovery of a product or process and the proof that it will work.
2.   Innovation is the first successful commercial introduction of a new product, the first use of a new production, or the creation of a new form of business enterprise.
3.   Diffusion is the spread of innovation through imitation or copying.
C.   Expenditures on research and development include direct efforts by business toward invention, innovation and diffusion.  Government also engages in R&D, particularly for national defence.
D.  The modern view of technological advance.
1.   For decades economists treated technological advances as an element largely external to the market system — a random outside force to which the economy adjusted.
2.   Contemporary economists see capitalism itself as the driving force of technological advance, providing the incentives and motives for firms and individuals to seek profitable opportunities.
II.        The role of entrepreneurs and other innovators.
A.  The entrepreneur is an initiator, innovator, and risk bearer—the catalyst who uses resources in new and unique ways to produce new and unique goods and services.
B.   Other innovators, who do not bear personal financial risk, include key executives, scientists, and others engaged in commercial R&D activities.
C.   Often entrepreneurs form new companies called “start-ups”, i.e., firms that focus on creating and introducing new products or employing a specific new production or distribution technique.
D.  Innovators are also found within existing corporations supported by working conditions and pay incentives that foster creative thinking.  Some firms have chosen to “spin off” the R&D function into new, more flexible and innovative companies.
E.   Product innovation and development are creative endeavours with intangible rewards of personal satisfaction, but the “winners” can also realize huge financial gains.  Success gives entrepreneurs and innovative firms access to more resources.  The entrepreneurs are found in many different countries around the world.
F.   Technological advance is supported by the scientific research of universities and government sponsored laboratories.  Firms increasingly help to fund university research that relates to their products.
III.       The firm’s optimal amount of R&D.
A.  Finding the optimal amount of R&D is an application of basic economics. 
1.   To earn the greatest profit, a firm should expand a particular activity until its marginal benefit equals its marginal cost. 
2.   The R&D spending decision is complex because the estimation of future benefits is highly uncertain while costs are immediate and more clear-cut.
B.   Interest rate cost of funds:  Whatever the source of R&D funds, the opportunity cost of these funds is measurable by the current rate of interest.  (See Figure 11-2) Possible sources include the following:
1.   Bank loans
2.   Bonds
3.   Retained earnings
4.   Venture capital
5.   Personal savings
C.   A firm’s marginal benefit from R&D is its expected rate of return on the expenditures.  The curve showing the expected rate of return slopes downward because of diminishing returns to R&D expenditures.  (See Figure 11-2)
D.  Optimal R&D expenditures occur when the interest rate cost of funds is equal to the expected rate of return.  (See Figure 11-3)
1.   Many R&D expenditures may be affordable but not worthwhile because the marginal benefit is less than the marginal cost.
2.   Expenditures are planned on the basis of expected returns.  R&D decisions carry a great deal of risk.  There is no certainty of outcome.
IV.       Increased profit via innovation.
A.  Increased profit via product innovation. 
1.   Consumers will buy a new product only if it increases the total utility they obtain from their limited incomes.  They purchase products that have the highest marginal utility per dollar.  (Review Chapter 6 and Table 6.1)
a.   Consumer acceptance of a new product depends on both marginal utility and price.
b.   The expected return that motivates product innovation may not be realized.  Expensive ‘“flops” are common.
c.   Most product innovation consists of incremental improvements to existing products rather than radical inventions.
B.   Reduced cost via process innovation.
1.   Firms can increase output by introducing better production methods or by using more productive capital equipment.
2.   An innovation that increases total product at each level of resource usage lowers the average total cost of a unit of output and thus enhances the firm’s profit.  (See Figure
11-4)

V.         Imitation and R&D Incentives
A.  A firm’s rivals may deliberately employ the “fast-second strategy,” allowing the originating firm to incur the high costs of R&D and then entering quickly if the product is a success.
B.   There are protections, potential advantages, and benefits of being first.
1.   Some technological breakthroughs can be patented; they cannot be legally imitated for two decades.  
2.   Copyrights and trademarks reduce the problem of direct copying.
3.   Along with trademark protection, brand name recognition may give the original innovator a marketing advantage.
4.   Trade secrets may prevent imitation of a product, and sometimes it is the process that is the key to success.  The originating firm may also gain an advantage simply by learning on the job.
5.   Time lags between innovation and diffusion often permit originating firms to realize a substantial economic profit.
6.   A final advantage of being first is the potential for an attractive buyout offer.  This allows the innovative entrepreneur to take their rewards immediately without the uncertainty of production and marketing on their own. 
7.  There continue to be high levels of R&D that would not be the case if imitation consistently and severely depressed actual rates of return on these expenditures.  (See Figure 11-6)
VI.       Role of Market Structure
A.  Market structure and technological advance.
1.   Pure competition—Although purely competitive firms may have an incentive to keep ahead of their competitors, the small size of the firms and the fact that there are no barriers to entry and therefore they can earn only a normal profit in the long run, leads to serious questions as to whether such producers can benefit from and finance substantial R&D programs.
2.   Monopolistic competition—There is a strong profit incentive to engage in product development in this market structure.  However, most firms remain small, which limits their ability to secure financing for R&D.  Economic profits are usually temporary because there are few barriers to entry.
3.   Oligopoly—The oligopolistic market structure is conducive to technical advance.   Firms are large with ongoing economic profits, are protected by barriers to entry, and have large volume of sales.  Although oligopolistic firms have the financial resources to engage in R&D, they are often complacent.
4.   Pure monopoly—Pure monopolists have little incentive to engage in R&D.  Since profits are protected by absolute barriers to entry, the only reason for R&D would be defensive, i.e., to reduce the risk of a new product or process that might destroy the monopoly.
B.   Inverted-U Theory (Figure 11-6)
1.   The inverted-U suggests that both very low concentration industries and very high concentration industries expend a relatively small percentage of their sales revenue on R&D.
2.   The optimal market structure for technological advance seems to be an industry in which there is a mix of large oligopolistic firms (a 40 to 60 percent concentration ratio) with several highly innovative smaller firms.
3.   Competitive firms are small, which makes it difficult for them to finance the R&D, and there is easy entry by competitors.  Where firms have a substantial amount of monopoly power, monopoly profits are large and innovation will likely not add much more to the the firm’s profits.
4.   The level of R&D spending within an industry seems to be determined more by the industry’s scientific character and “technological opportunities” than from its market structure.
VII.     Technological Advance and Efficiency
A.  Productive efficiency is improved when a technological advance involves process innovation and a reduction in costs.  (Figure 11-4a and b)
B.   Allocative efficiency is improved when a technological advance involves a new product that increases the utility consumers can obtain from their limited income.
C.   Innovation can create monopoly power through patents or the advantages of being first, reducing the benefit to society from the innovation.
D.  Innovation can also reduce or even disintegrate existing monopoly power by providing competition where there was none.  In this case, economic efficiency is enhanced because the competition drives prices down closer to marginal cost and minimum ATC. 
E.   Creative destruction occurs when the innovation of new products or production methods destroys the monopoly positions of firms committed to existing products and their old ways of doing business.
VIII.    Last Word: On the Path to the Personal Computer and Internet
Technological advance is clearly evident in the development of the modern personal computer and the emergence of the Internet.  This is a brief history of these events.

ANSWERS TO END-OF-CHAPTER QUESTIONS

11-1     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?
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
11-2     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.
a.   An auto manufacture 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 maker of light bulbs becomes the first firm to produce and market lighting fixtures using halogen lamps.
e.   A rival toy maker introduces a new Jenny doll to complete with Mattel’s Barbie doll.
(a)  DIF
(b)  INN
(c)  INV
(d)  INN
(e)  DIF
11-3     Contrast the older and 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 increasingly becoming more like entrepreneurs and less like “pure scientists”?
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, labour 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.
11-4     (Key Question) Suppose a firm expects that a $20 million expenditure on R&D will result in a new product which will increase its revenue by a total of $30 million 1 year from now.  The firm estimates that the production cost of the new product will be $29 million.
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?  Explain why or why not.
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?  Explain.
(a)  5 percent;
(b)  No, because the 5 percent rate of return is less than the 6 percent interest rate;
(c)  Yes, because the 5 percent the rate of return is now greater than the 4 percent interest rate.
11-5     (Key Question) Answer the lettered questions below on the basis of the information in this table:

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?
(a)  $50 million, where the interest-rate cost of funds (i) equals the expected rate of return (r);
(b)  at $20 million in R&D, r of 14 percent exceeds i of 8 percent, thus there would be an under-allocation of R&D funds;
(c)  at $60 million, r of 6 percent is less than i of 8 percent, thus there would be an over-allocation of R&D funds.
11-6     (Key Question) Refer to Table 11-1 and suppose the price of new product C is $2 instead of $4.  How does this affect the optimal combination of products A, B, and C for the person represented by the data?  Explain:  “The success of a new product depends not only on its marginal utility but also on its price.”
(a)  The person would now buy 5 units of product C and zero units of A and B;
(b)  The MU/price ratio is what counts; a new product can be successful by having a high MU, a low price, or both relative to existing products.
11-7     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 those developing imitative products?
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.
11-8     (Key Question) Answer the following questions on the basis of this information for a single firm:  total cost of capital = $1,000; price paid for labour = $12 per labour unit; price paid for raw materials = $4 per raw-material unit.
a.   Suppose the firm can produce 5,000 units of output by combining its fixed capital with 100 units of labour and 450 units of raw materials.  What are the total cost and average total cost of producing the 5,000 units of output?
b.   Now assume the firm improves its production process so that it can produce 6,000 units of output by combining its fixed capital with 100 units of labour and 45 units of raw materials.  What are the total cost and average cost of producing the 6,000 units of output?
c.   In view of your answers to 8a and 8b, explain how process innovation can improve economic efficiency.
(a)  Total cost = $4,000; average total cost = $.80 (= $4,000/5,000 units);
(b)  Total cost = $4,000, average total cost = $.667 (= $4,000/6,000 units);
(c)  Process innovation can lower the average total cost of producing a particular output, meaning that society uses fewer resources in producing that output.  Resources  are freed from this production to produce more of other desirable goods.  Society realizes extra output through a gain in efficiency.
11-9     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 products?
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 products introduction and its imitation, and the possibility of lucrative buyout offers from larger firms’.
11-10   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?
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.
11-11   Make a case that neither pure competition nor pure monopoly is very conducive to a great deal of R&D spending and innovation.  Why is oligopoly more favourable to R&D spending and innovation than either pure competition or pure monopoly?  What is the inverse-U theory and how does it relate to your answers to these questions?
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 make 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 11-8) The inverted-U theory reiterates the assessment made above regarding likely R&D spending and market structure.
11-12   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.”
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.
11-13   (The Last Word) Identify a specific example of each of the following in this Last Word:
a.   entrepreneurship,
b.   invention,
c.   innovation, and
d.   diffusion.
(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 Engbart 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.

Consider This
Pharmaceutical companies in Canada  now have 20 years of protection for a new drug they come up with before generic drug companies are allowed to produce the same drug. Is such a long period warranted?
Many people believe that 20 years is too long. But the very large investment that must be made to bring new pharmaceuticals to market requires that a firm must be able to get a competitive return on its very risky investments. Remember that some drugs are never approved even after a long testing period, meaning that the resources put into that drug will not be recovered. So for a pharmaceutical company, the successful new drugs must also cover the expenses incurred in their unsuccessful drugs.