Lecture 2 - Innovation

1. Innovation and R&D: Core Concepts

1.1 What Is Innovation?

Innovation is defined as the application of new ideas to products, processes, or other aspects of a firm’s activities that lead to increased economic value. Crucially, innovation is not imitation or adoption. It involves novelty and the creation of something genuinely new.

Innovation is a multi-stage phenomenon:

  • Creation of knowledge through invention or discovery
  • Diffusion of new knowledge across firms and markets
  • Realisation of social and economic benefits

This distinction matters because private incentives to innovate do not generally align with social benefits.

1.2 Types of Innovation

Two main types of innovation are distinguished:

  • Product innovation

    • Introduction of a new product or a significant qualitative improvement in an existing product
    • Examples include new pharmaceuticals or major software upgrades

  • Process (technological) innovation

    • Introduction of a new method of producing or delivering goods and services
    • Often reduces marginal or average costs and can generate a cost advantage

Both types can generate market power, either through differentiation or cost leadership.

1.3 Research and Development (R&D)

R&D refers to systematic activities aimed at generating innovation. It includes:

  • Basic research

    • Creation of new knowledge without a specific commercial application in mind
    • Often undertaken by universities or public research institutions

  • Applied research

    • Application of existing knowledge to solve practical problems
    • Aimed at improving performance, reliability, or quality

  • Development

    • Systematic work building on applied research
    • Translates ideas into marketable products or processes

2. Measuring Innovation and R&D Activity

2.1 R&D Spending

R&D spending is the monetary value of resources devoted to research and development.

At the firm level:

  • Absolute R&D spending measures scale
  • R&D intensity measures commitment relative to firm size:

At the country level:

R&D intensity is preferred in empirical analysis because it allows meaningful comparison across firms and countries.

2.2 Empirical Patterns in R&D

Empirical evidence shows that:

  • Global R&D spending is highly concentrated in a small number of industries
  • Software, internet, health, and hardware sectors account for a disproportionate share
  • R&D intensity differs substantially across countries and over time

These patterns suggest that innovation incentives depend strongly on industry characteristics and market structure.

3. Innovation as a Source of Market Failure

Innovation markets exhibit several forms of market failure that lead to socially suboptimal levels of R&D.

3.1 Knowledge as a Public Good

New knowledge is:

  • Non-rival: one firm’s use does not reduce availability to others
  • Non-excludable: difficult to prevent others from using it

Production of knowledge involves:

  • Large sunk costs
  • Near-zero marginal cost of use

As a result, private provision of knowledge is insufficient relative to the social optimum.

3.2 Spillover Effects

Innovation generates positive production externalities:

  • Other firms benefit from an innovator’s R&D without paying for it
  • Social benefits exceed private benefits

This spillover effect causes firms to underinvest in R&D from a social perspective.

3.3 Indivisibility, Uncertainty, and Capital Constraints

R&D investment:

  • Requires large, indivisible sunk costs
  • Is highly uncertain, with a significant probability of failure
  • Often needs external finance

Small firms may be unable to obtain funding due to risk and imperfect capital markets, even when projects are socially valuable.

3.4 Patent Races and Duplication

When multiple firms pursue the same innovation:

  • They may duplicate research efforts
  • Firms engage in rent-seeking behaviour
  • Total R&D spending can become socially wasteful

This is known as a patent race, where competition leads to excessive duplication rather than efficient knowledge creation.

3.5 Monopoly Power from Intellectual Property Rights

Patents and copyrights grant exclusive rights to innovators:

  • Allow firms to obtain monopoly power
  • Enable recovery of sunk R&D costs

However, monopoly outcomes are inefficient:

  • Higher prices
  • Restricted output
  • Deadweight loss

Thus, innovation policy involves a trade-off between incentives and static efficiency.

4. Policy Responses to Innovation Market Failures

4.1 Public Provision and Subsidies

Governments can:

  • Fund basic research directly
  • Subsidise private R&D

This addresses underinvestment caused by spillovers and public good characteristics.

4.2 Cooperation and Research Joint Ventures

Firms may collaborate through:

  • Research Joint Ventures (RJVs)
  • Shared research platforms

Benefits include:

  • Internalisation of spillovers
  • Risk sharing
  • Reduction in duplication

However, cooperation may also facilitate tacit collusion, requiring regulatory oversight.

4.3 Protection of Intellectual Property Rights

IPR protection provides:

  • Exclusive rights to innovators
  • Incentives to invest in R&D

Without effective IPR, firms cannot appropriate returns and innovation incentives collapse.

4.4 Antitrust Regulation

While IPR create monopoly power, antitrust policy aims to:

  • Prevent abuse of dominance
  • Protect consumers
  • Preserve dynamic competition

This reflects the tension between promoting innovation and limiting market power.

4.5 Licensing and Technology Markets

Patent holders may:

  • Sell licences
  • Engage in cross-licensing
  • Participate in patent pools

Licensing facilitates:

  • Sequential and complementary innovations
  • Faster diffusion of technology
  • Reduced innovation bottlenecks

5. Innovation and Market Structure

5.1 A Non-Linear Relationship

The relationship between innovation and market structure is:

  • Complex
  • Non-monotonic
  • Bilateral

Empirical evidence suggests an inverted U-shaped relationship between competition and R&D.

5.2 Innovation Incentives by Market Structure

Monopoly

  • Modest incentives to innovate
  • Gains from innovation are small relative to existing monopoly profits
  • Opportunities are strong due to access to finance and risk-bearing capacity

Highly Competitive Industries

  • Weak incentives to innovate
  • Potential gains are large, but:
    • Firms lack resources
    • Risk of duplication is high
    • Probability of success is low

Concentrated Industries

  • Strongest incentives to innovate
  • Significant potential gains
  • Firms are large enough to finance R&D
  • Easier collaboration and spillover management

This explains why innovation is often highest in oligopolistic industries.

6. Key Takeaways and Exam Focus

Summary Points

  • Innovation creates value but suffers from market failures
  • Knowledge is a public good with spillovers
  • R&D is risky, sunk, and capital-intensive
  • IPR both incentivise innovation and create monopoly power
  • Innovation and market structure interact in a non-linear way

Exam Tips

  • Clearly distinguish private versus social returns to innovation
  • Explain why laissez-faire leads to underinvestment
  • Use the inverted U-shape to discuss competition and R&D
  • Link innovation policy tools to specific market failures