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1 Course outline I n Introduction n Game theory n Price setting – monopoly – oligopoly n Quantity setting – monopoly – oligopoly n Process innovation Homogeneous goods

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2 Innovation competition n Product versus process innovation n Drastic versus non-drastic innovation n Patent race n Incentives to innovate n Executive summary

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3 Research and development n Three levels of research: – fundamental research – applied research with project planning – development of new products and their commercialization n Innovation of product and process n Three stages – invention – adoption – diffusion

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4 Five models n Patent race with respect to process innovation n Process innovation leads to reduction of average cost: n Incentives to innovate for – benevolent dictator – monopolist – perfect competition – two symmetric firms – two asymmetric firms

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5 Benevolent dictator v. monopolist p xx incentive to innovate MR p

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6 Drastic v. non-drastic innovation p x p x non-drastic innovation drastic innovation Innovator enjoys blockaded monopoly,

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7 Exercise (drastic or non-drastic innovation) n Inverse-demand function p=a-X n All firms have identical unit costs, where n Only one firm reduces its unit cost to Infer kind of innovation

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8 n Incentives to innovate – for drastic innovation – for non-drastic innovation Perfect competition (compare next slide and slide Benevolent dictator v. monopolist)

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9 graphically

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10 Assumptions and notation for dyopolistic innovation competition n Patent race with respect to process innovation n R&D expenditure of firms 1 and 2: n A measure of innovation difficulty : n Innovation probability of firm i: n Probability of no innovation:

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11 Exercise (innovation probability) How does the innovation probability depend on F 0, F 1 and F 2. 0 F 0 100F 0 F 0 34F 0 F 0 6F 0 ½ F 0 F 2 F 1 Innovation probability of firm 1

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12 Symmetric innovation competition 1 2 F 1 F 2 Initially, none of the firms is in the market. The successful firm enters the market and receives

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13 Equilibrium (symmetric case) n Profit function of firm 1 n Reaction function of firm 1 n Nash equilibrium,

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Nash equilibrium

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15 Exercise (sequential symmetric case) Consider the symmetric case with F 0 =0. Calculate an equilibrium in the sequential game:

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16 n Monopolist (firm 1) with average cost, and potential competitor (firm 2) n Process innovations leads to reduction of average cost: n Profits, net of R&D expenditure – No firm innovates – Established firm innovates – Entrant innovates (price competition) Asymmetric case: one incumbent, one potential competitor 1 2 p 1 p 2 F 1 F 2

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17 Profit functions (asymmetric case) n Profit function of firm 1 (monopolist) n Profit function of firm 2

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18 Incentives to innovate No firm innovates. Monopolist innovates. Entrant innovates.

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19 Replacement effect (Arrow) n The Arrow terms are defined as the profit differences a firm enjoys by innovating rather than not innovating. n If the incumbent innovates, he replaces himself. If the entrant innovates, he achieves positive profits as compared to zero profits:

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p x p x Incentive to innovate from replacement effect for established firm for potential competitor nondrastic innovation drastic innovation

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21 Efficiency effect (Gilbert, Newbery) n The Gilbert-Newbery terms are defined as the profit differences a firm enjoys if she herself rather than her competitor innovates. n The established firms incentive to remain a monopolist is greater then the entrants incentive to become a duopolist:

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22 Gilbert-Newbery effect: deterrence and < in equation (1) blockade and = in equation (1) From previous slide follows: Drastic innovation firm 2 Nondrastic innovation firm 2 equation on previous slide is true

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23 Replacement versus efficiency effect n Replacement effect – entrant has a greater incentive to innovate n Efficiency effect – established firm has a greater incentive to innovate

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24 Equilibrium (asymmetric case) n Reaction function of firm 1 n Reaction function of firm 2 n Nash equilibrium: forget it

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25 Identifying the replacement effect n The greater the monopolys profit without innovation, the less are the monopolists incentives to innovate:

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26 Special case: efficiency effect only n Hypothesis : F 0 = 0 i.e., it is certain that one of the two firms innovates n Reaction function of firm 1 n Reaction function of firm 2 n Nash equilibrium :

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27 Executive summary I n The higher the attainable monopoly profit, the higher the expenditures for R&D in the patent- race Nash equilibrium. n The less likely successful innovation, the less all firms expenditures for R&D. n R&D expenditures might be strategic complements or strategic substitutes. n Sometimes, it may pay for the monopolist to file a patent but not to actually use it himself (sleeping patent).

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28 Executive summary II Incentives to innovate for the asymmetric duopoly: n If the incumbent innovates, he replaces himself. If the entrant innovates, he achieves positive profits as compared to zero profits. replacement effect n The established firms incentive to remain a monopolist rather than becoming a duopolist is greater then the entrants incentive to become a duopolist. efficiency effect

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29 Innovation competition with spill- over effect n Basic idea n Simultaneous quantity competition (2 nd stage) n Simultaneous R&D competition (1 st stage) n Simultaneous R&D cooperation (1 st stage) n Comparison of R&D competition and R&D cooperation n Executive summary

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30 Basic idea n It is often not possible to internalise the benefits of R&D activities perfectly: – employee turnover – analysis of patents n R&D cooperation can be observed in some industries (e.g. PSA has different cooperation projects). On the product market, the firms may still compete.

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31 The model n Before the innovation n The innovation reduces costs by n measures the spill-over effect. n F i...R&D activity; C(F i )...costs of R&D activity n Structure x 1 x 2 F1F2F1F2 to

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32 Profit function n Profit functions assume:

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33 Cournot competition (2 nd stage) n Reaction functions n Cournot equilibrium n Reduced profit functions

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34 How Cournot outputs depend on n real R&D activity n R&D activity

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35 Exercise (R&D competition on 1 st stage) n Assume Find the symmetric equilibrium in the R&D game.

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36 Analyzing direct and indirect effects (R&D competition) I Influence of F 1 on firm 1s profit =0 >0 =0 direct effect strategic effect <0

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37 n Influence of F 1 on firm 2s profit =0 ? direct effect strategic effect >0<0 Analyzing direct and indirect effects (R&D competition) II

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38 n We assume that firms cooperate on the first stage and compete on the second. Therefore: n Firms want to maximize the joint reduced pro- fit function n While assuming the same quadratic cost func- tion as before, calculate the cartel solution. Exercise (R&D cooperation on 1 st stage)

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39 Profit comparison of R&D competition and R&D cooperation

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40 n Does R&D competition yield higher R&D activities than cooperation? n In our concrete model, we find Analytical comparison of competition v. cooperation

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41 Graphical comparison of competition v. cooperation

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42 n The influence of firm 1 on firm 2s profit is an external effect; see slide Analyzing direct and indirect effects (R&D competition) II n We found n Bingo! Interpreting the comparison by way of external effects

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43 Executive summary: If spillover effects are sufficiently important, n Firms want to underinvest in R&D for strategic reasons; n Firms want to cooperate in order to prevent suboptimal R&D activities; n Governments may allow R&D cooperation in order to enhance R&D activities.

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