Chapter 26 - PowerPoint

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					           Project status
• Concerns
• Solution details
• Interactions and impacts
 Topics:
 •Invention, innovation, diffusion
 •Role of entrepreneur and other innovators
 •A firms optimal amount of R&D
 •Increased profit via innovation
 •Imitation and R&D incentives
 •Role of market structures
 •Technological advance and efficiency


Technology, R&D, and Efficiency
The microeconomics of technological advance
    Technology, R & D, and Efficiency


• 1968 Nike – now >$10 billion in sales
• 1967 Intel – now worlds largest producer of
  microprocessors
• 1962 Wal-Mart – now annual revenues > $300
  Billion

• Keys to success – Technological Advance
• New and better goods and services or new and
  better ways of producing or distributing them.
    Technology, R & D, and Efficiency


• The pursuit of technological advance is
  a major competitive action among
  firms.

• Focus on the Very Long Run
  A period of time in which technology
  can change and in which firms can
  develop and offer entirely new
  products.
                  Technological advance
Three step process of technological advance
1. Invention
        The discovery of a product of process through the use
        of imagination, ingenious thinking, and
        experimentation and the first proof that it will work.
•       A process - inventing
•       A result
    –      The prototype of the telephone, automobile, microchip
    –      Glue invented in 1750, air brakes 1868, aspirin 1829
    –      Most U.S. patents: 1,811 - Japanese inventor, Shunpei Yamazaki age 65
           mostly in the field of L.C.D.'s memory chips

        Usually based on scientific knowledge and is the product of individuals,
        either working on their own or as members of an organization R&D
        staff.
               Technological advance
2. Innovation
    Draws directly on invention (the discovery and first proof of
    workability). Cannot be patented.
Innovation – the first successful commercial introduction of a new
    product, the first use of a new method, or the creation of a new
    form of business enterprise. Check the CES show in Las Vegas
Two types:
Product innovation – new and improved products or
   services (Cosmetics, Food, Cars, Netflix , Redbox
Process innovation – new and improved methods of production
    or distribution (printing, assembly, distribution, power generation)
         Technological advance
3. Diffusion
The spread of an innovation through imitation or copying.
New and existing companies emulate successful innovations
  of others.
• Alamo car rental – unlimited mileage
• Daimler Chrysler – luxury version of Jeep Grand
  Cherokee
• 1996 Palm Pilot – Microsoft, handspring, blackberry
• What others can you think of?
Innovation led eventually to widespread imitation.
U.S. R&D EXPENDITURES

   Applied Research Basic Research
      (Invention)
          22%           6%
                               Development
                           (Innovation & Imitation)


                             72%

                                           2002 Data


                              Source: National Science Foundation
   Role of Entrepreneurs and other innovators
• Entrepreneurs as individuals – the name
  – Andrew Carnegie – steel
  – Henry Ford – automobiles
  – Levi Strauss – blue jeans

• Entrepreneurs as groups
  – Teams – in same company or a group of companies
  – Groups of entrepreneurs
  – Executives, scientists, salaried employees engaged in
    commercial R&D activities – Intrapreneurs.

• Forming start-ups
  – Focus on creating and introducing a new product or
    employing a new production or distribution technique
     •   Apple Computer
     •   Starbucks
     •   Amazon
     •   Wal-mart
     Role of Entrepreneurs and other innovators
• Innovating within existing firms
    – Salaried workers
    – Substantial bonuses or shares of profits
    – “spin-off firms” – to avoid the red tape
        • Lucent Technologies – from AT&T
        • Imation - from 3M
•   Anticipate the future

• Exploit university and government scientific research
    – Basic scientific research
        • Cannot be patented, no immediate commercial use
        • Entrepreneurs study output from university and government labs
        • Breakthroughs
            – Hybrid seed corn
            – Satellite communications
            – Computer mouse
        • Sharing in potential profit
        • BP and UC Berkley - $500 million energy research consortium
    – Some firms conduct their own basic research
        • Pharmaceutical industry
        • Technology
A firm’s optimal amount of R&D
Q. How does a firm decide on its optimal amount of R&D?
A. Depends on its perception of MB and MC of R&D.
     Present sacrifice versus future expected gain

•     Interest-Rate Cost-of-Funds – the MC
    –     Several ways of obtaining funds for R&D.
         • Bank Loans – cost of using the funds (interest rate)
         • Bonds – MC of using the funds (interest rate)
         • Retained Earnings – MC of using the funds (interest rate)
         • Venture Capital – MC of venture capital – share of profits
             (interest rate)
         • Personal Savings – MC is the foregone (interest rate)
         • Marginal cost of using the funds – interest rate
         • Graph of the MC of each funding amount yields the interest-rate
             cost-of-funds curve.
•     Expected Rate-of-Return – the MB
    –    The firm’s MB from R&D – expected profit (or return) from the last
         (marginal) dollar spent on R&D.
    –    Expected, not certain
    –    Expected-Rate-of-Return-Curve
A FIRM’S OPTIMAL AMOUNT OF R&D



   Expected Rate of Return, - r, Interest Rate i
                                                                                      Interest-Rate Cost Expected-Rate of
                                                   20                                   of Funds Rate Return Schedule
                                                                                                                   Exp.
                                                   16                                                          R&D Ret. %
                                                                                                                $10 18
                                                                                                                 20 16
                                                   12
                                                                                                                 30 14
                                                                                                                 40 12
                                                   8                                                             50 10
                                                            Expected-rate of                                     60 8
                                                   4        return curve (MB curve)                              70 6
                                                                                                                 80 4
                                                                                                     r
                                                        0        20        40         60      80         100
                                                                   R&D Expenditures
                                                                      (millions of dollars)
A FIRM’S OPTIMAL AMOUNT OF R&D



  Expected Rate of Return, - r, Interest Rate i
                                                                                       Interest-Rate Cost Expected-Rate of
                                                  20                                     of Funds Rate Return Schedule
                                                                                                                    Exp.
                                                                                            8%
                                                  16                                                            R&D Ret. %
                                                                                                                 $10 18
                                                                                                                  20 16
                                                  12
                                                                                                                  30 14
                                                                                                                  40 12
                                                  8                                                       i       50 10
                                                           Interest-rate cost
                                                           of funds curve (MC curve)                              60 8
                                                  4                                                               70 6
                                                                                                                  80 4
                                                                                                      r
                                                       0        20        40           60      80         100
                                                                   R&D Expenditures
                                                                     (millions of dollars)
                                                     A FIRM’S OPTIMAL

Expected Rate of Return, - r, Interest Rate i
                                                      AMOUNT OF R&D
                                                                            Interest-Rate Cost Expected-Rate of
                                                20                            of Funds Rate Return Schedule
                                                                                                         Exp.
                                                                                  8%
                                                16                                                   R&D Ret. %
                                                                            Optimal                   $10 18
                                                                              R&D                      20 16
                                                12                         Expenditure                 30 14
                                                                           $60 Million                 40 12
                                                8                                              i       50 10
                                                                 r=i                                   60 8
                                                4                                                      70 6
                                                                                                       80 4
                                                                                           r
                                                     0   20        40       60        80       100
                                                          R&D Expenditures
                                                              (millions of dollars)
                                                             A FIRM’S OPTIMAL

        Expected Rate of Return, - r, Interest Rate i
                                                              AMOUNT OF R&D
                                                                                    Interest-Rate Cost Expected-Rate of
                                                        20                            of Funds Rate Return Schedule
                                           Exp.
                                                                                          8%
        16                             R&D Ret. %
                          Optimal       $10 18
Two Important Points:       R&D          20 16
        12
•Optimal vs. Affordable R&D (MB
                         Expenditure vs. MC)
                                         30 14
                         $60 Million     40 12
•Expected, not Guaranteed, Returns i 50 10
         8
                   r=i                   60 8
         4                               70 6
                                         80 4
                                                                                                   r
                                                             0   20        40       60        80       100
                                                                  R&D Expenditures
                                                                      (millions of dollars)
    Increased profit via innovation
Q. How does technological change increase a firm’s
   profit?
A. By increasing revenue or reducing production costs.

    Increased Revenue via Product Innovation

•     Thousands of new products introduced each
      year
     – All reflect technological advance in the form
        of product innovation.
 Increased profit via innovation
Q. How do such new products gain consumer
   acceptance?
A. Consumers will buy a new product only if it
   increases the total utility they obtain from their
   limited incomes.

      “Dollar votes” represent new product demand that yields
         increased revenue.

      Total profit rises by the per-unit profit multiplied by the
         number of units sold.

      The rise in total profit is the return on that R&D
         expenditure – the basis of the expected rate of returns
         curve.
Increased profit via innovation
                       Related Points

 –    Importance of Price
     • Consumer acceptance of a new product depends on both
        its marginal utility and its price.
     • To be successful, a new product must not only deliver
        utility to consumers but do so at an acceptable price.

 –    Unsuccessful New Products
     • Millions of dollars of R&D and promotion expense
        resulted in loss. What are some examples?

 –    Product Improvements
     • Most product innovations consist of incremental
        improvements to existing products rather than radical
        inventions.
    Reduced cost via process innovation

         The introduction of better methods of producing products
         (process innovation) is also a path toward enhanced profit
         and a positive return on R&D expenditures.

•        Introduction of a new and better process
     –     The innovation yields an upward shift in the firm’s total product curve
     –     A downward shift in the firm’s average-total-cost curve.
     –     Enhances the firm’s profit.

•        Example
     –     Wal-mart computer based inventory control system
     –     Just in time delivery of inventory
     –     Transportation innovations
     –     Distribution systems
Increased Profit via Innovation
            Process innovation               And lowers the cost per
            yields more output       Average   unit of labor and
      Total                           Total
     Product per unit of labor        Cost enables a greater output
                               TP2

      2500                     TP1
                                                                 ATC1
      2000
                                                                 ATC2
                                       $5
                                        4


        0                               0
                   1000                              2000 2500
              Units of Labor                   Units of Output
             Imitation and R&D incentives
Fast-Second Strategy
    The dominant firm counts on its own product improvement
    abilities, marketing prowess, or economies of scale to prevail.

   – reverse engineering
   – let smaller firms incur the high costs of innovation, then
     move quickly to imitate.
   – Goal is to become the fast second

Examples:
• Diet cola – Royal Crown was first, but Diet Coke and Diet
   Pepsi dominate
• Low cal beer – Meister-Brau was first, Miller popularized
   with Miller Lite
• Microsoft, Proctor and Gamble, Amazon.com, JVC, Heinz
             Imitation and R&D incentives
Benefits of Being First

Q. What incentive is there to be first given the ease of imitation?
A. There are some protections for and potential advantages.

    Some inventions can be patented
      protection for 20 years
             Polaroid’s patent on the instant camera
             Kodak “cloned” but lost a patent infringement suit
             Prescription drugs
             Pop-top cans
             Imitation and R&D incentives
                          Protections:

Copyrights protect publishers of books, computer software,
  movies, videos and musical compositions from having their
  works copied.
      video games

Trademarks give the original innovator of products the exclusive
  right to use a particular product name
      “M&M’s”
      Barbie Doll
      Wheaties

By reducing the problem of direct copying, these legal protections
  increase the incentive for product innovation.
               Imitation and R&D incentives
Brand-Name Recognition may give the original innovator a major marketing
  advantage for years.

   – We often identify a product with the firm that first introduced it
      • Levi’s blue jeans or Dockers
      • Kleenex tissues
      • Johnson and Johnson’s Band-Aids
      • Kellogg's Corn Flakes
      • Xerox copiers
      • Disney

• Brand equity - measures the total value of the brand to the
  brand owner, and reflects the extent of brand franchise

• Brand promise - "Carl's Steak House -"Our food is the best,
  but the memories we help you create are even better”

• Brand personality – serious, playful, warmth
             Imitation and R&D incentives
Trade Secrets
  Coca-Cola’s secret formula
  Chemical industry
  Seeds

Learning by doing
  The development of special production techniques known only
  to the innovator.
       Chemical industry
       Cosmetics

The innovator’s lower cost may enable it to continue to profit
  even after imitators have entered the market.
                Imitation and R&D incentives
Time lags between innovation and diffusion often enable
  innovators to achieve substantial economic profit.

  Competitor must:
   – gain knowledge
   – design a substitute product
   – gear up a factory
   – conduct marketing campaigns
   – acquire customers

Profitable Buyouts – significant advantage of being first
  Jibbitz – accessories for Crocs shoes, bought out by
  Crocs for $20 Million. Crocs today?
       http://www1.jibbitz.com/
         Role of market structure
  Is there a particular market structure or firm
  size that is best suited to technological
  advance?
• Pure Competition
  – Positive
     • Strong competition provides strong incentive
     • Many firms, no stone unturned
  – Negative
     • Expected rate of return may be low or negative
     • Advantage quickly lost to new entrants, other firms
     • Normal profit in the long run
         Role of market structure
  Is there a particular market structure or firm
  size that is best suited to technological
  advance?
• Monopolistic Competition
  – Positive
     • Cannot afford to be complacent
     • Strong profit incentive
     • Start out as monopolist competitors locally and grow
        – McDonald's, Blockbuster Video, Krispy Crème Donuts
  – Negative
     • Most remain small, limited resources to fund R&D
     • Long run normal profit typically
             Role of market structure
  Is there a particular market structure or firm size
  that is best suited to technological advance?
• Oligopoly
   – Positive
      • Large size, financial resources
      • Barriers to entry
      • Large sales volume
   – Negative
      •   Often, low incentive to innovate
      •   Complacency can be a problem
      •   Avoid making current equipment obsolete
      •   Steel, cigarette, and aluminum industries only modest interest in
          R&D.
         Role of market structure
  Is there a particular market structure or firm
  size that is best suited to technological
  advance?
• Pure Monopoly
  – Little incentive to innovate
  – Defensive action if threatened
  – Least conducive to innovation
Inverted -U theory of the relationship between market structure
and technological advance




               as a Percent of Sales   MORE COMPETITION            LESS COMPETITION
                R&D Expenditures

                                                       Loose oligopoly




                                           R&D expenditures as a % of sales rise
                                           With industry concentration until the
                                           Concentration ratio reaches about 50%.




                                  0       25          50         75                       100
  Pure competition                                                                  Pure monopoly
                                        Concentration Ratio (Percent)
             Technological advance and efficiency

• Improves Productive Efficiency
  – By increasing the productivity of inputs
  – By reducing average total costs
  – Society can produce the same amount of a particular good
    or service while using fewer scarce resources, freeing up
    unused resources to produce other goods and services.
  – Leads to shifting an economy’s production possibilities
    curve rightward.
Technological advance and efficiency

• Improves Allocative Efficiency
   – Technological advance as embodied in product (or service)
     innovation enhances allocative efficiency by giving society
     a more preferred mix of goods and services.
   – Demand for new products goes up
   – Demand for old products goes down
   – Resources continue to shift until the price of the new
     product equals its MC.
                 Technological advance and efficiency

• Facilitates Creative Destruction
   – New products and new production methods simultaneously
     destroy monopoly market positions or firms committed to
     existing products or production techniques.
   – Examples
      •   1800’s wagons, ships, and barges - the railroad
      •   Railroads – trucks and airplanes
      •   Snail mail - Email
      •   Sears and Kmart - Wal-Mart
technological advance   venture capital
very long run           interest-rate cost-of-funds
invention                  curve
patent                  expected-rate-of-return curve
innovation              optimal amount of R&D
product innovation      imitation problem
process innovation      fast-second strategy
diffusion               inverted-U theory of R&D
start-ups               creative destruction

				
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