Governance of innovation
Lecture 1: competition and innovation
How to encourage innovation?
- Ideas lead to innovations, which lead to growth and development (because of positive
externalities).
- The problem is that ideas are scarce, which constrains growth.
- Therefore, to get innovation, we need to have the will to innovate (including a good idea) and
the means to innovate (as it is costly).
- Innovation-support systems/ institutions must provide the means (or incentives to obtain the
means).
- In many cases, the current prominent incentive scheme (called intellectual property) is
inferior to some form of procurement (= “bemiddeling”).
o Sometimes you get prizes, sometimes public sponsorships, sometimes grants, etc.
- What are the effects of successful innovations? How to govern these effects best?
Given that market structure (= level of competition in an industry) and profits (shapes incentives) are
highly correlated and innovation efforts (inputs), and results (outputs) are correlated, what is the
relationship between the degree of competition in an industry and the innovation efforts of firms?
Does competition discourage or reinforce innovation?
2 competing hypotheses:
- Schumpeterian effect = increased competition reduces innovation
o Firms with monopoly rents have higher incentives to innovate to protect their market
position and discourage entry
- Escape-competition effect = increased competition increases innovation
o Firms in very competitive industries have higher marginal profits from innovating
o When they are successful, they can earn positive profits instead of 0 profits.
Measuring competition and innovation: causality
- Aghion et al. (2005) use industry-year data
o We develop a model where competition discourages laggard firms (already low initial
profits) from innovating but encourages neck-and-neck firms to innovate.
- Measure of innovation = average number of patents in the industry (each patent weighted by
the number of citations of other patents)
- Measure of competition = Lerner index (price cost margin)
o (p-MC)/MC or (operating profit – financial cost)/sales
o The higher, the more the industry comes close to a monopoly
- To address the endogeneity problem, the causality from competition to innovation is studied
with an IV approach:
o 3 sets of policies are used as instruments for changes in competition, which were
exogenous to the industry-level innovation.
Thatcher era privatizations
Break trade unions open trade more competition
EU Single Market Program harmonization of rules more competition
UK Monopoly and Merger Commission’s investigations many cartels
were exposed more competition
Main result
- Inverted U-shape relationship between competition and innovation
o For low levels of competition, the escape-competition effect dominates
Incremental profits from innovating are high
, o For high levels of competition, the Schumpeterian effect dominates
Industry laggards have low incentives to innovate
- Innovation incentives depend not so much upon postinnovation rents, as in previous
endogenous growth models where all innovations are made by outsiders, but upon the
difference between postinnovation and preinnovation rents of incumbent firms. In this case,
more competition may foster innovation and growth, because it may reduce a firm's
preinnovation rents by more than it reduces its postinnovation rents. In other words,
competition may increase the incremental profits from innovating, and thereby encourage
R&D investments aimed at "escaping competition." This should be particularly true in sectors
where incumbent firms are operating at similar technological levels; in these "neck-and-neck"
sectors, preinnovation rents should be especially reduced by product market competition. On
the other hand, in sectors where innovations are made by laggard firms with already low
initial profits, product market competition will mainly affect postinnovation rents, and
therefore the Schumpeterian effect of competition should dominate.
Main result: explanation
- Industries with more competition have a higher average technology spread within the industry
( = low neck-and-neckness).
o Different effect of competition for leaders and laggards: as firms innovate to escape
from competition, they increase the technology spread within the industry.
- Inverted U-shape steeper in more neck-and-neck industries
o Underlines stronger innovation incentives for firms in industries with low technology
spread.
- Confirmed by lab experiments in 2018.
Individual innovation incentives
- Intellectual property is a legal barrier, created so that the investor is compensated for his
efforts.
- We want to compare the advantages and disadvantages of IP to alternative solutions that also
try to foster innovation (e.g., prizes).
Knowledge and information goods are public goods
- Public goods:
o Non-rival = high cost to create the good, but it costs nothing to distribute it or use it
once it is there.
o Non-excludable = IP will not work in this case.
- For efficiency, we would set a price = MC = 0 (competitive equilibrium which generates the
highest welfare)
- The problem is that innovators have to recur their fixed costs of the investment made, and
they also want a premium, because otherwise there are few incentives to innovate in the first
place.
- A frequent solution is to use IP.
o Knowledge (how to make a product) is protected, not the product per se.
o Today’s patent law: applicant must disclose a template when he applies for a patent.
What does IP do?
- It creates excludability
- It provides at least as a weak efficiency test: does the value of the investment exceed the cost?
- Decentralizes responsibility for innovation market determines innovations, not the
government or institutions.
- Con: Does a bad job at delegation
o Does not privilege the most efficient firms
o Does not regulate entry and duplication of innovations
- Con: IP leads to deadweight loss monopoly pricing.
, - Pro: if ex ante perspective is taken (how to spur innovation in the future, not to allocate the
existing innovation efficiently), IP has 3 virtues.
o The expected monopoly rents in the future incentivize R&D spending today
o IP decentralizes R&D decisions no central authority has to negotiate with a would-
be innovator about the renumeration
o Because of the costs of IP borne by its users (paying monopoly price, not the
competitive price), the ex-post beneficiaries pay for innovation, not the taxpayer in
general (this is especially positive if the new product is for a narrow customer group).
Each innovation is paid for voluntarily through proprietary prices. When
innovations are funded out of general revenue, there is no guarantee that the
benefits received by any individual taxpayer outweigh that taxpayer’s share
of the cost. This argument in favor of intellectual property protection is
particularly convincing for innovations with a narrow clientele, such as
computer games or other whimsical things, but has less force for innovations
with widely dispersed benefits.
- Still, there is a negative view on IP from the ex-post perspective (DWL).
The problem of disclosure
- Knowledge is a public good
- 2 typical user groups:
o End users’ consumption: they get the new products/services
o Researchers’ investment: as a foundation for new discoveries, that is, knowledge can
be used for consumption or research.
- Patented inventions must be disclosed because of the following reasons:
o Rivals and courts must know what is claimed (= the patent’s teaching)
o Courts do not have to make it up afterwards
o Facilities follow-on innovation
o Puts the technology in the public domain after expiration.
Breadth and the required inventive step
- In most patent laws, the following 2 requirements are present:
o Required inventive step = which innovations are protectable? invention should be
sufficiently inventive (i.e., non-obvious).
Patents will be granted only to inventions which, among other things, involve
an inventive step, that is, the invention, having regard to the state of the art,
must not be obvious to a person skilled in the art.
o Patent breadth = how different must another product be to be patentable as well?
Broader patent means that the product must differ a lot to be patentable.
Lecture 1: competition and innovation
How to encourage innovation?
- Ideas lead to innovations, which lead to growth and development (because of positive
externalities).
- The problem is that ideas are scarce, which constrains growth.
- Therefore, to get innovation, we need to have the will to innovate (including a good idea) and
the means to innovate (as it is costly).
- Innovation-support systems/ institutions must provide the means (or incentives to obtain the
means).
- In many cases, the current prominent incentive scheme (called intellectual property) is
inferior to some form of procurement (= “bemiddeling”).
o Sometimes you get prizes, sometimes public sponsorships, sometimes grants, etc.
- What are the effects of successful innovations? How to govern these effects best?
Given that market structure (= level of competition in an industry) and profits (shapes incentives) are
highly correlated and innovation efforts (inputs), and results (outputs) are correlated, what is the
relationship between the degree of competition in an industry and the innovation efforts of firms?
Does competition discourage or reinforce innovation?
2 competing hypotheses:
- Schumpeterian effect = increased competition reduces innovation
o Firms with monopoly rents have higher incentives to innovate to protect their market
position and discourage entry
- Escape-competition effect = increased competition increases innovation
o Firms in very competitive industries have higher marginal profits from innovating
o When they are successful, they can earn positive profits instead of 0 profits.
Measuring competition and innovation: causality
- Aghion et al. (2005) use industry-year data
o We develop a model where competition discourages laggard firms (already low initial
profits) from innovating but encourages neck-and-neck firms to innovate.
- Measure of innovation = average number of patents in the industry (each patent weighted by
the number of citations of other patents)
- Measure of competition = Lerner index (price cost margin)
o (p-MC)/MC or (operating profit – financial cost)/sales
o The higher, the more the industry comes close to a monopoly
- To address the endogeneity problem, the causality from competition to innovation is studied
with an IV approach:
o 3 sets of policies are used as instruments for changes in competition, which were
exogenous to the industry-level innovation.
Thatcher era privatizations
Break trade unions open trade more competition
EU Single Market Program harmonization of rules more competition
UK Monopoly and Merger Commission’s investigations many cartels
were exposed more competition
Main result
- Inverted U-shape relationship between competition and innovation
o For low levels of competition, the escape-competition effect dominates
Incremental profits from innovating are high
, o For high levels of competition, the Schumpeterian effect dominates
Industry laggards have low incentives to innovate
- Innovation incentives depend not so much upon postinnovation rents, as in previous
endogenous growth models where all innovations are made by outsiders, but upon the
difference between postinnovation and preinnovation rents of incumbent firms. In this case,
more competition may foster innovation and growth, because it may reduce a firm's
preinnovation rents by more than it reduces its postinnovation rents. In other words,
competition may increase the incremental profits from innovating, and thereby encourage
R&D investments aimed at "escaping competition." This should be particularly true in sectors
where incumbent firms are operating at similar technological levels; in these "neck-and-neck"
sectors, preinnovation rents should be especially reduced by product market competition. On
the other hand, in sectors where innovations are made by laggard firms with already low
initial profits, product market competition will mainly affect postinnovation rents, and
therefore the Schumpeterian effect of competition should dominate.
Main result: explanation
- Industries with more competition have a higher average technology spread within the industry
( = low neck-and-neckness).
o Different effect of competition for leaders and laggards: as firms innovate to escape
from competition, they increase the technology spread within the industry.
- Inverted U-shape steeper in more neck-and-neck industries
o Underlines stronger innovation incentives for firms in industries with low technology
spread.
- Confirmed by lab experiments in 2018.
Individual innovation incentives
- Intellectual property is a legal barrier, created so that the investor is compensated for his
efforts.
- We want to compare the advantages and disadvantages of IP to alternative solutions that also
try to foster innovation (e.g., prizes).
Knowledge and information goods are public goods
- Public goods:
o Non-rival = high cost to create the good, but it costs nothing to distribute it or use it
once it is there.
o Non-excludable = IP will not work in this case.
- For efficiency, we would set a price = MC = 0 (competitive equilibrium which generates the
highest welfare)
- The problem is that innovators have to recur their fixed costs of the investment made, and
they also want a premium, because otherwise there are few incentives to innovate in the first
place.
- A frequent solution is to use IP.
o Knowledge (how to make a product) is protected, not the product per se.
o Today’s patent law: applicant must disclose a template when he applies for a patent.
What does IP do?
- It creates excludability
- It provides at least as a weak efficiency test: does the value of the investment exceed the cost?
- Decentralizes responsibility for innovation market determines innovations, not the
government or institutions.
- Con: Does a bad job at delegation
o Does not privilege the most efficient firms
o Does not regulate entry and duplication of innovations
- Con: IP leads to deadweight loss monopoly pricing.
, - Pro: if ex ante perspective is taken (how to spur innovation in the future, not to allocate the
existing innovation efficiently), IP has 3 virtues.
o The expected monopoly rents in the future incentivize R&D spending today
o IP decentralizes R&D decisions no central authority has to negotiate with a would-
be innovator about the renumeration
o Because of the costs of IP borne by its users (paying monopoly price, not the
competitive price), the ex-post beneficiaries pay for innovation, not the taxpayer in
general (this is especially positive if the new product is for a narrow customer group).
Each innovation is paid for voluntarily through proprietary prices. When
innovations are funded out of general revenue, there is no guarantee that the
benefits received by any individual taxpayer outweigh that taxpayer’s share
of the cost. This argument in favor of intellectual property protection is
particularly convincing for innovations with a narrow clientele, such as
computer games or other whimsical things, but has less force for innovations
with widely dispersed benefits.
- Still, there is a negative view on IP from the ex-post perspective (DWL).
The problem of disclosure
- Knowledge is a public good
- 2 typical user groups:
o End users’ consumption: they get the new products/services
o Researchers’ investment: as a foundation for new discoveries, that is, knowledge can
be used for consumption or research.
- Patented inventions must be disclosed because of the following reasons:
o Rivals and courts must know what is claimed (= the patent’s teaching)
o Courts do not have to make it up afterwards
o Facilities follow-on innovation
o Puts the technology in the public domain after expiration.
Breadth and the required inventive step
- In most patent laws, the following 2 requirements are present:
o Required inventive step = which innovations are protectable? invention should be
sufficiently inventive (i.e., non-obvious).
Patents will be granted only to inventions which, among other things, involve
an inventive step, that is, the invention, having regard to the state of the art,
must not be obvious to a person skilled in the art.
o Patent breadth = how different must another product be to be patentable as well?
Broader patent means that the product must differ a lot to be patentable.
