1 Economics of Innovation Innovation and market structure: Introduction Manuel Trajtenberg

2 Arrow: Innovation/Knowledge as an economic good Innovation: creation of new knowledge. Knowledge (K) as public good: Non-rival in use, and hard to exclude (but not impossible) Intangible, K spreads, easy to copy, to imitate. Source of spillovers. Paradox with demand – need to know K to assess its value, but once you know it, won’t want to pay for it…

3 Characteristics of Knowledge Creation High fixed cost, trivial/low costs of reproduction or transmission (wasn’t always like that…) Very high uncertainty (risk aversion may prevent undertaking R&D as much as socially desirable) “Moral hazard” problem (cannot contract out “creativity efforts”); hard to shift risks. Appropriability problem: hard to keep benefits just in the hands of innovator, who pays for the fixed cost (e.g. R&D).

4 Market Failures in R&D/Innovation Special characteristics of Knowledge & K-creation: sources of market failure, hence presumption that market forces cannot render enough R&D, enough innovation (even less so for basic research). Basic tensions: between incentives to innovate on the one hand, and reaping the full social benefits from innovation. K leaks, diffuses => good for the economy as a whole, bad for the individual inventor.

5 Secrecy Lead time Other rewards (prestige, prizes, etc.) Those involving IPR (intellectual property rights): Patents (clause in the US constitution!) Copyrights Mechanisms of Appropriability

6 Innovation and Market Structure What works well for innovation - competition or monopoly? Static versus dynamic efficiency The Schumpeterian Hypothesis

7 (Production) Process Innovation D MC 1 MC 0 P0P0 P1P1 P X X1X1 X0X0

8 Product Innovation D1D1 MCP0P0 P XX1X1 X0X0 D0D0 D1D1 P0P0 P XX1X1 X0X0 D0D0 P1P1

9 Invention of a New Product D MC 1 “MC 0 ” P X X1X1 X0X0

10 Social benefits from process innovation D MC 1 MC 0 P0P0 P1P1 P X X1X1 X0X0

11 Profits for firm that starts in competitive market and gets a patent (thus solving appropriability problem) D MC 1 MC 0 P0P0 P1P1 P X X1X1 X0X0 (for case of non-drastic innovation)

12 Profits for monopoly firm D MC 1 MC 0 P0P0 P1P1 P X X1X1 X0X0 MR

13 Investment in R&D and market structure The “value” of innovation: V S > V C > V M Ranking could change if (then very different results throughout!): Monopoly can better internalize (some of the) spillovers. Finite effective patent and/or easier imitation for competitive firm, longer protection for monopoly (e.g. barriers to entry).

14 The question is: R&D > < V i ? I.e. would the innovation take place? If R&D > V S => should not innovate If V S > R&D > V C should innovate but markets will not. If V C > R&D > V M competitive markets will, monopoly will not. If V M > R&D both competitive markets and monopoly will innovate. R&D and Market Structure - continued

15 R&D and Market Structure – cont. 2 Disparity between V S and V C, V M could be much more significant if large spillovers: ( V S + spillovers) >> V C, V M => main determinant of policy Room for government intervention, e.g. subsidize R&D – see Chief Scientist Programs in Israel; see Vaanevar Bush, “Science: The Endless Frontier”, 1945.