R&D, Innovation and Networks

Basic research, applied research, and development are three components of R&D. Basic research is described as the theoretical work undertaken in order to obtain novel knowledge from the fundamentals of a phenomenon and/ or fact that will not necessarily lead to specific application or use. Applied research, on the other hand, involves investigations aimed at determining potential uses for basic research findings. This kind of research is usually directed at a more practical and specific usage than basic research. The final component of R&D is experimental development. The development stage includes work that is aimed at producing new products/ processes or upgrading existing ones by employing knowledge obtained from research and practical
experience.

Innovations are distinguished between two types according to their objective. Product innovations change the firms’ products so that a new or improved good or service differing notably from the previous ones should be introduced on the market. Process innovations, on the other hand, change the firm’s business processes so that a new or improved business process that differs significantly from the firm’s previous processes should be brought into use in the firm.

Drastic innovations diminish a firm’s unit cost so that even if it levies the monopolist price, it will charge less than its rivals. So drastic innovations allow the innovator to behave as a monopolist without being constrained by price competition for some time.
However, non-drastic innovations provide the innovator firm some cost advantage over its rivals, but the firm is constrained by competition.Non-drastic innovation does not alter the market price and the quantity purchased by the consumer. In the non-drastic innovation case, the innovator sells to the entire market and gains positive profit. Drastic innovation, on the other hand, decreases the market price and increases the quantity purchased. Moreover, the monopoly price charged by the innovator decreases below the initial cost in drastic innovation since the cost reduction is so large. This helps the innovator to apply the monopoly price without facing the competition threat from the other firms. In the case of non-drastic innovation, the innovator cannot behave as a monopolist due to the price competition of the rivals, even if it gains some cost advantage.

The gain from buying the patent right of the innovation for a monopolist firm will be the extra profit it will attain due to producing at a lower marginal cost. Since the monopolist firm maximizes profit by equating marginal cost to marginal revenue, we can compute the additional gain from introducing innovation. To do so, we have to calculate the monopolist’s profit at the prevailing marginal cost and compare it with the profit that the firm will obtain at the lower marginal cost due to innovation.

The monopolist and the competitive firms underrate innovation compared to the social planner motivated by maximizing the total welfare. Moreover, a competitive firm will be willing to pay more for the patent right than the monopolist firm so that the innovator’s profit, and, hence, the incentives for innovation, will be higher in competitive than monopolist markets. The difference between the competitive firm and the monopolist lies in the fact that the monopolist earns profit with its existing technology while the competitive firm does not. Once the monopolist adopts the new process, it replaces and weakens that prevailing investment. This effect is called the replacement effect.

A potential entrant values innovation less than the incumbent, even though the incumbent monopolist preserves its monopoly position or not by innovation. The incumbent will prefer to replace itself rather than be replaced by a potential entrant. This effect is categorized as the efficiency effect.

In their study, Dasgupta and Stiglitz demonstrate that as the number of firms in the industry rises, the total R&D expenditure may either decrease or increase depending on the market demand elasticity. Total R&D expenditure will increase if the elasticity of market demand is sufficiently large. In the case of relatively elastic market demand, the increase in the industry output due to the larger number of firms will not reduce the price level and the marginal revenue too much. If we think of the case of linear demand curves, as the output increases, a fall in the elasticity of the market demand will be seen. This will cause a decrease in total R&D expenditure if the number of firms increases beyond some point. Adding up one more firm to the number of existing firms will cause a decrease in total R&D expenditure even if there are quite a small number of firms in the market.

Less concentrated industries will allocate a smaller share of their total sales revenue to R&D expenditure. To put it differently, the industries that are by nature more competitive will conduct less R&D compared to others. This conclusion offers a robust theoretical confirmation for Schumpeter’s hypothesis that imperfect competition is conducive to technological progress

The R&D expenditures will be strategic complements when research spillovers are high, as demonstrated by upward-sloping research intensity reaction functions. An expansion in research intensity done by one of the firms motivates the other firm to increase its research intensity. If one firm chooses a higher amount of R&D effort, the gains from this R&D activity will spill over to the other firm to the degree that the profit expansion of the other firm yields that firm more funds and a motivation to increase its R&D expenditure.

The output equation indicates that the larger β (the level of R&D spillovers) is, the more each firm will spend on R&D. The coordination between two firms makes every single firm internalize the external gains that R&D activity has on its competitor. This also helps to avoid the free-riding problem so that the firms will each have a profit level at least as large as the amount they would obtain in the case of no cooperation.

The activities generating information and knowledge are subject to three sources of market failure: externalities, indivisibilities, and uncertainty.

R&D investments involve both technological uncertainty through the risks involved and commercial uncertainty through the failure of adoption by consumers.

Intellectual property (IP) is the legal rights assigned to the creators of new ideas, inventions, new processes, and methods of production. The IP laws and regulations grant the exclusive right to use the protected knowledge to its creator. The IP laws resolve, to some extent, the underproduction problem resulting from the non-excludability character of knowledge, but they generate an underutilization problem by providing exclusive monopoly rights to the owner itself.

IP laws provide exclusive rights for a limited period to counterbalance these two problems. At first, IP laws create excludability by granting exclusive rights to the owner for a certain period (usually 20 years), and then the knowledge becomes accessible to all users at its marginal cost once the legal protection is terminated.

Dynamic efficiency is about the creation of knowledge, whereas static efficiency involves the promotion of the diffusion and use of the created knowledge. Therefore, dynamic efficiency requires the most extended possible protection to maximize the incentives for creating new knowledge, and static efficiency requires the non-existence of protection to prevent deadweight loss generated through the monopolist’s right to knowledge.

the market for that product is defined as exhibiting network externalities or scale economies with demand-side. The term “network” is used to characterize the group of users that acquire benefits depending on each other due to the nature of the product they are utilizing.

The indirect network effects are not directly related to the good or service but are revealed by complementary goods.

The existence of network externalities  causes the market to be smaller than optimal.

If the firms in the network market compete, the lowfraction equilibrium is important for them since firms that do not extend to this “critical mass” will not succeed in surviving.

If we compare two equilibrium prices with and without network effects, we observe that the equilibrium
prices are lower in the presence of network effects. The value of capturing an additional consumer from a rival firm is larger since the additional consumer initiates other consumers to be ready to pay more for the firm’s service.