1. THE ECONOMY: THE CORE PROJECT

2. UNIT 21. INNOVATION, INFORMATION AND THE NETWORKED ECONOMY

3. T21.1 Innovation and innovation systems
Which of the following statements regarding innovation is correct?
Select one answer
The invention of mobile phone technology can be classified as radical innovation, while the latest app developed for smartphones is an incremental innovation.
Innovation rent is what the user of a patented innovation has to pay during the term of the patent.
With its importance in green technology, solar panel can be classified as a general purpose technology.
An innovation system is the system employed by firms in order to maximise its innovation opportunities.
Section 21.1

4. ANSWER: T21.1 Innovation and innovation systems
Which of the following statements regarding innovation is correct?
Feedback
The invention of mobile phone technology gives rise to completely new and different products (smartphones, for example), whereas a new app is an improvement of an existing product.
Innovation rent is what a firm earns in profits above opportunity cost of capital after a successful innovation.
General purpose technologies are those that are applied in many industries, such as electricity and transportation (railroads, automobile, airplanes). The solar panel in its current use is not a general purpose technology.
An innovation system refers to the relationships among private firms, governments, educational institutions, individual scientists and other actors involved in the invention, modification, and diffusion of new technologies, and the way that these social interactions are governed by a combination of the laws, policies, knowledge and social norms in force.
Select one answer
The invention of mobile phone technology can be classified as radical innovation, while the latest app developed for smartphones is an incremental innovation.
Innovation rent is what the user of a patented innovation has to pay during the term of the patent.
With its importance in green technology, solar panel can be classified as a general purpose technology.
An innovation system is the system employed by firms in order to maximise its innovation opportunities.
Section 21.1

5. T21.2 Codified and tacit knowledge
Which of the following statements regarding codified and tacit knowledge is correct?
Select one answer
In the banking industry, the product description of a new financial product (such as credit derivatives in the 1990s) is codified knowledge, while the skills of successful traders and structured product teams are tacit knowledge.
The venture capital funding system of Silicon Valley promotes tacit knowledge of skilled workers rather than invention of codified knowledge.
The export industries of Germany rely on codified knowledge, with patents that heavily cite scientific articles.
The German innovation system involves high employee mobility across firms, which helps to distribute the tacit knowledge acquired in one firm to other firms.
Section 21.2

6. ANSWER: T21.2 Codified and tacit knowledge
Which of the following statements regarding codified and tacit knowledge is correct?
Feedback
Product descriptions can be accurately written down, whereas successful trading skills cannot.
Venture capitalists accept high project failures in return for inordinately large returns from few successful ventures. This system promotes radical innovation of codified knowledge.
The export industries of Germany rely on incremental innovation where patents are much less intensive in scientific citations and tacit knowledge tends to be more important.
The German innovation system involves long-term employment contracts and the social norm that assures that highly trained workers will not be poached by rivals. Instead long-run inter-firm collaboration over technology development and industry-wide standard setting facilitates technology transfer.
Select one answer
In the banking industry, the product description of a new financial product (such as credit derivatives in the 1990s) is codified knowledge, while the skills of successful traders and structured product teams are tacit knowledge.
The venture capital funding system of Silicon Valley promotes tacit knowledge of skilled workers rather than invention of codified knowledge.
The export industries of Germany rely on codified knowledge, with patents that heavily cite scientific articles.
The German innovation system involves high employee mobility across firms, which helps to distribute the tacit knowledge acquired in one firm to other firms.
Section 21.2

7. T21.3 Complements and substitutes
The figure shows the payoffs for two firms depending on whether they innovate or not. The first number is the payoff for JVC (VHS) while the second number is for Sony (Betamax). Based on this information, which of the following statements is correct?
Select one answer
In this game, the two innovations are substitutes.
There are two Nash equilibria in this game, (Innovate, Innovate) and (Not innovate, Not innovate).
JVC (VHS) will definitely innovate, because its payoff is higher when both firms innovate.
There is nothing that the government can do to promote the socially optimal outcome in this game.
Section 21.3

8. ANSWER: T21.3 Complements and substitutes
The figure shows the payoffs for two firms depending on whether they innovate or not. The first number is the payoff for JVC (VHS) while the second number is for Sony (Betamax). Based on this information, which of the following statements is correct?
Feedback
The payoff from one firm’s innovation is higher when the other firm also innovates. Therefore, the two innovations are compliments.
If both firms innovate, neither firm can get a higher payoff by choosing not to innovate. Similarly, if both firms do not innovate, any firm that chooses to innovate will receive a lower payoff.
In the case that Sony (Betamax) does not innovate, JVC (VHS) is better off not innovating as well. Therefore, it is not certain whether JVC (VHS) would innovate.
The government can encourage both to innovate, for example by providing subsidies or by promising not to prosecute them for any anti-competitive practices if they choose to coordinate decision making.
Select one answer
In this game, the two innovations are substitutes.
There are two Nash equilibria in this game, (Innovate, Innovate) and (Not innovate, Not innovate).
JVC (VHS) will definitely innovate, because its payoff is higher when both firms innovate.
There is nothing that the government can do to promote the socially optimal outcome in this game.
Section 21.3

9. T21.4 Demand-side economies of scale through network effects
The following graph shows a hypothetical market for Sony Betamax and JVC VHS video machines. The qualities of Betamax and VHS video machines are given by qB and qV, respectively, where qB > qV. The number of buyers are nB and nV, where nB + nV = 10,000. The price of both machines is the same at p. The benefit of purchasing a machine increases with the total number of users of that machine and is given by Πx = qxnx – p, where x = B or V. Based on this information, which of the following statements is correct?
Select one answer
The buyers get a positive benefit from purchasing a machine even if there is no other buyer for that machine.
Buyers are always better off buying the better quality machine, Betamax.
The economies of scale from network effects means that the lower quality machine (VHS) can dominate the market.
The government can increase the aggregate benefit of buyers by ensuring that there are enough buyers of both machines, through competition.
Section 21.4

10. ANSWER: T21.4 Demand-side economies of scale through network effects
The following graph shows a hypothetical market for Sony Betamax and JVC VHS video machines. The qualities of Betamax and VHS video machines are given by qB and qV, respectively, where qB > qV. The number of buyers are nB and nV, where nB + nV = 10,000. The price of both machines is the same at p. The benefit of purchasing a machine increases with the total number of users of that machine and is given by Πx = qxnx – p, where x = B or V. Based on this information, which of the following statements is correct?
Feedback
If nobody currently owns a machine (nx = 0), the first buyer receives a negative benefit (Πx = -p < 0). This is also shown by the negative intercept on the y-axes.
This is not true when the number of Betamax buyers is small (see the graph). An extreme case is when nB = 0 when ΠB = -p < 0. In fact, ΠB > ΠV only when qBnB – p > qVnV – p  qBnB > qVnV, which can be shown to be true for nB > 1,000qV / (qB + qV) (using nB + nV = 10,000). In the graph this is shown to be 4,000.
VHS can dominate the market if the total number of VHS users is greater than 6,000, which makes it more beneficial for new buyers to choose VHS. This outcome could occur if VHS was the first established machine in the market.
The highest aggregate benefit is attained when all buyers choose Betamax. The fact that this may not be attained through competition is due to the “lock in” effect of the “winner-take-all” competition.
Select one answer
The buyers get a positive benefit from purchasing a machine even if there is no other buyer for that machine.
Buyers are always better off buying the better quality machine, Betamax.
The economies of scale from network effects means that the lower quality machine (VHS) can dominate the market.
The government can increase the aggregate benefit of buyers by ensuring that there are enough buyers of both machines, through competition.
Section 21.4

11. T21.5 Matching (two-sided) markets
Which of the following statements regarding matching markets is correct?
Select one answer
The fish market is an example of a two-sided matching market because sellers and buyers do not care about who they are selling to or buying from.
Due to the benefits from a match, a platform for a matching market would always be created when new opportunities are discovered.
A two-sided matching market results when the two activities required to make a match are strategic substitutes.
In Job Opportunities for Economists, an employment clearing matching market, the activities of the employers and new PhD economists are strategic complements.
Section 21.5

12. ANSWER: T21.5 Matching (two-sided) markets
Which of the following statements regarding matching markets is correct?
Select one answer
The fish market is an example of a two-sided matching market because sellers and buyers do not care about who they are selling to or buying from.
Due to the benefits from a match, a platform for a matching market would always be created when new opportunities are discovered.
A two-sided matching market results when the two activities required to make a match are strategic substitutes.
In Job Opportunities for Economists, an employment clearing matching market, the activities of the employers and new PhD economists are strategic complements.
Feedback
In a two-sided matching market, buyers and sellers do care about who they are matched with (for example, the marriage market).
There is a chicken-and-egg problem with the creation of two-sided markets: unless there are already enough participants, there is no reason for one to develop the platform, but without a platform there will not be any participants.
Two activities are strategic substitutes when the more that one is performed, the smaller are the benefits of performing the other. In this case, a two-sided matching market would not be created.
The more employers that post jobs on the platform, the more that job applicants will use that platform. Therefore, job-seeking and job-posting are strategic complements.
Section 21.5

13. T21.6 Patents and the production of new knowledge using old knowledge
The figure is a schematic representation of the innovation process, where arrows represent inputs, pointing towards the aspects of innovation that they affect. Based on this information, which of the following statements is correct?
Select one answer
Patents slow down the use of old knowledge in creating new knowledge.
Patents encourage innovation and the creation of new knowledge by allowing inventors easy access to the old knowledge.
By slowing diffusion, patents maximise the economy’s benefits from new knowledge.
The negative effects of patents always outweigh the positive effects.
Section 21.6

14. ANSWER: T21.6 Patents and the production of new knowledge using old knowledge
The figure is a schematic representation of the innovation process, where arrows represent inputs, pointing towards the aspects of innovation that they affect. Based on this information, which of the following statements is correct?
Select one answer
Patents slow down the use of old knowledge in creating new knowledge.
Patents encourage innovation and the creation of new knowledge by allowing inventors easy access to the old knowledge.
By slowing diffusion, patents maximise the economy’s benefits from new knowledge.
The negative effects of patents always outweigh the positive effects.
Feedback
Patents prevent old knowledge from being used to create new knowledge, by granting the inventor exclusive rights to their idea.
Patents inhibit access to the old knowledge.
By slowing diffusion, patents inhibit the economy’s benefits from new knowledge.
Economists disagree about whether the beneficial effects more than offset the negative effects.
Section 21.6

15. T21.7 The optimal probability of innovation for society
The figure shows the feasible set of total benefits to society from innovation, defined as the probability of innovation (p) multiplied by the total benefits to others if innovation occurs (B), and the isototal benefit curves. Based on this information, which of the following statements is correct?
Select one answer
There is a positive probability of innovation even when the patent never expires.
At D, the feasible frontier is upward-sloping because increasing patent duration encourages more innovation.
The isototal benefit curves join all points for which the total benefits to others if innovation occurs is equal.
Point A is preferred to point E as the total benefits to others if innovation occurs is higher at A than at E.
Section 21.7

16. ANSWER: T21.7 The optimal probability of innovation for society
The figure shows the feasible set of total benefits to society from innovation, defined as the probability of innovation multiplied by the total benefits to others if innovation occurs, and the isototal benefit curves. Based on this information, which of the following statements is correct?
Feedback
When the patent never expires (total benefits to others = 0), inventors can receive more private benefits from innovating, so innovation will still occur.
The x-axis is increasing in the total benefits to others from innovation, which is decreasing in the duration of patent. Therefore at D, the feasible frontier is upward-sloping because the decreasing patent duration encourages the use of patented knowledge for further innovation.
That would imply vertical lines. The iso-total benefit curves join all points at which the value pB is equal, i.e. the unconditional total benefits, not total benefits if innovation occurs.
If that is the case then C would be preferred to A. A is preferred to both E and C because the total benefits (and not total benefits if innovation occurs) is higher, putting it on a higher isototal benefits curve.
Select one answer
There is a positive probability of innovation even when the patent never expires.
At D, the feasible frontier is upward-sloping because increasing patent duration encourages more innovation.
The isototal benefit curves join all points for which the total benefits to others if innovation occurs is equal.
Point A is preferred to point E as the total benefits to others if innovation occurs is higher at A than at E.
Section 21.7