As an assignment for the course of Economics of Innovation at UCL, I was asked to post a comment to an interesting article published on the blog “IPdigIT” (http://www.ipdigit.eu/2010/09/what-is-the-link-between-competition-and-innovation/) that offers a quick and inspiring overview on how competition (or a lack of it) might relate with the innovation process of a firm.
In a nutshell, I wanted to write down my thoughts about monopolies in particular, to try and understand how a strong market position could affect (or even prevent) Research and Developement in firms in such a position. You can find it later in this short post, but ,if you have the time, I strongly suggest a reading of the original article, the references that it cites (which give a better and more complex picture of how economists have tried to study this matter, during the last decades) and maybe a few comments.
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Determining how firms with a sound and dominant (if not monopolistic) position in the market innovate is a tough call. Apparently, at a first glance, there is no incentive to innovate at all, bringing us to the point of thinking that a lack of competition might cause a lack of innovation.
One clear motivation to this point of view is that a firm in such a position already has a consumer base that lets the firm just go on with its standard level of production (therefore limiting R&D expenditure to a minimum, as Arrow pointed out in “Economic Welfare and the Allocation of Resources for Invention”, dated 1962), making business without being bound to offer better products than its competitors. We have to consider that innovation is not a smooth, easy process, as Holmes, Levine and Schmitz showed in “Monopoly and the incentive to innovate when adoption involves switchover disruptions”. As a monopolistic firm operates on a fairly low level of produced units, the marginal cost of R&D could be unbearable, as the innovation process has not immediate healthy and useful effects, and subsequently cause a disincentive to further innovation. Moreover, a bold move could drastically change the consumers’ perception of the product itself, eventually even bringing to a sharp decline in sells, in favour of a substitute good (if any exists) or simply quitting buying it.
On the other hand, if the firm sells a very important good, which does not have a substitute, innovation could be taken into account. Schumpeter in “Capitalism, Socialism and Democracy” (1942) wrote about this very topic, pointing out that a monopolistic firm should use its position and capital power to enhance its production and push down hard on the innovation throttle, as the risks of a negative outcome would be absolutely rare and bearable, due to the market position.
So, how can we think of innovation in such a situation? An answer could be that of an opening of the market: if barriers to entry are low enough to let another (or multiple) seller to enter the market, that might be an incentive to develop something new to avoid being beaten by the newcomers. “The future of technology”, a book published by The Economist, cites as an example that several “disrupting” firms which entered some IT market (namely, the telephone and photocopies one, for example), exploited the lack of innovation by the established firms that were dominating the sectors, to the point of becoming the new leaders in the market. These episodes can be associated with the Gilbert-Newbery model (1982), which illustrates how a firm which operates in a monopoly is basically in front of a two-way fork: innovate or let (better, risking of letting) a possible rival to innovate.
This one is a clear example of an incentive for innovating, even when the firm is in a monopolistic market: otherwise, there is the risk of being challenged, maybe even to the point of being outdated and outperformed by a new and better technology. Of course, this argument applies only to markets that can open up to at least two actors: if a monopoly is not going to become a duo(or even an oligo-)poly, as Arrow assumed in his work, then the risk of being challenged is clearly non-existent.
Even if the debate is still somewhat opened between the opposite points of view (the one that comes from Schumpeter’s work and the one that derives from Arrow’s), at least to my eyes this is the most impellent reason for a firm to never settle and always try to invest in something new and possibly innovative. Of course, a monopolistic firm will most probably sell a number of goods such that the marginal cost of R&D will be higher than it would be in a competitive market, but going for a sound innovative process could nonetheless help improve the products and open up a future in which sales figures might grow and create a heathy “cycle”. Empirical evidence has actually shown that openness to innovation (i.e. limiting the use of patents and trying to spread the competition to greater levels) leads to a more flourish economic growth.
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My original comment is posted at: http://www.ipdigit.eu/2010/09/what-is-the-link-between-competition-and-innovation/#comment-27543
Di Stefano Caliò
Economia spicciola 