Chapter 2: Innovation: what is is? Flashcards
Sources of competitive advantage
Sustained competitive advantage can be derived from a number of sources depending on the theory we employ (see e.g. Connor 1991).
• Neoclassical theory of the firm
• Bain-type industrial organization
• Schumpeter’s response
We can think of ‘competitive advantage’ to refer to the company’s ability to generate above normal profits.
Neoclassical theory of the firm
Traditionally firms are defined by their productive activities.
• A set of feasible production plans give rise to the production function, mapping input bundles into output.
• Managers decide what and how much to produce.
• They also decide how (by means of which inputs) to produce.
• The firms traditionally own the right to access the factors of input:
Labor
Capital
• Firms operate under perfect competition.
Neoclassical theory of the firm
• The assumption of perfect competition ensures…?
the right combination of input factors is available and known (the cost function is derived from the production function)
• the firm can calculate the marginal contribution of each of the factors at every level of output
• all firms and all households (consumers) have perfect and complete information
• no inertia in resource allocation, resources are mobile and divisible
Neoclassical theory of the firm
• Firms features?
Firms are identical due to the perfect information.
• they have access to the same production technology
• each firm can obtain the inputs required at the required amount and quality
• All firms in a market are equally able and capable to combine the factors
of input into the demanded goods and services.
• Firms produce only a single output.
• With the atomistic structure of competition this leads to zero profits.
Advantages of large firms?
Advantages of larger firms (over smaller firms) could potentially originate from cost advantages: Larger firms might have lower unit costs than smaller ones.
• Sources of this cost advantage.
• Economies of scale - cost advantages from producing more of the same product.
• Economies of scope - cost advantages from producing a larger variety of products.
Economies of scale
Generally are generated by indivisibilities = Scaling inputs in accordance with the outputs is not possible.
• Reasons for indivisibility:
• Long-run fixed costs
• Set-up costs
• Specialized resources and division of labor
• Volumetric returns to scale (e.g. capacity depends on the volume of the container, cost depends on the surface)
• Economies of massed reserves (e.g. low level of output still requires large inventories of spare parts…)
Economies of scope
• Cost advantages from producing a larger variety of products
C(q1, q2) < C(q1, 0) + C(0, q2)
• These are caused by indivisibility as well.
• Sharing of production equipment (indivisible) for the two goods
• Common costs
• Knowledge in the production process
Neoclassical theory of the firm and relation to Economies of Scale and Scope
Firms are small (relative to the whole market)
• they produce one product
⇒ economies of scope do not play a role.
• they produce with a production technology that generates increasing average costs after a threshold (which is small relative to the market size).
⇒ economies of scale do not play a role.
The factor limiting firm size is the production technology (giving rise to the cost function).
Bain-type industrial organization - origin?
Goes back to Joe S. Bain (1912-1991)
US economist with a strong interest in industry and competition
Developed the structure conduct performance approach
Trivia: Bain did his PhD under the supervision of Joseph A. Schumpeter
Bain-type industrial organization
Firms try to maximize their profits by increasing market power.
• Market power allows the firms to restrain their output (produce less than firm under perfect competition).
increase prices (increase the mark-up)
remember (p − c)/p is a measure for market power
• Practices to gain or maintain market power
Collusion
Vertical integration
Horizontal mergers
Create barriers to entry: advertising, R&D
Bain-type industrial organization
The practices (might) harm consumers and the overall welfare.
• Very prominent here is the relationship between firm size and profits.
• The major approach in the Bain-Type IO is Structure-ConductPerformance.
• In the neoclassical model dis-economies of scale (increasing average costs) limit the size of the firm.
one-product-firms have no access to economies of scope.
• Bain-Type IO is not convinced that this is a realistic assumption.
The limits to size and market power is governmental intervention through antitrust policy.
Structure-conduct-performance
SCP is the traditional approach in Industrial Organization.
• Dates back to studies carried out in the early 1950 by Bain and by Mason
• Assumptions:
There is a stable, causal relationship between
• structure of an industry
• firm conduct
• market performance
Structure-conduct-performance
Structure?
Number and size distribution of buyer and sellers • Conditions for entry and exit • Product differentiation • Vertical integration • Diversification
Structure-conduct-performance
Conduct?
Business objectives • Pricing policies • Product design, branding, advertising and marketing • Research & development • Collusion • Merger
Structure-conduct-performance
Performance?
Profitability
• Growth
• Quality of products and services
• Productive and allocative efficiency
Structure-conduct-performance - Pt. 2
(Relatively) easy to observe:
• Market structure
• Performance
Research idea:
• Establish a link between the market structure and the performance of firms
• That holds across industries.
Key assumptions underlying the SCP approach
• The line of causality runs from structure to conduct to
performance (not the other way!).
• Key concepts used can be measured by available data.
Pi = Alpha + B1 CONi + B2BEi1 + B3Bei2 + ..+ B(n+1) BE in
***Typical empirical setup: π market power (captured by excess profits), α constant, β coefficients of
the structural variables (CON is concentration, BEj is a number of barriers to entry)
Porter’s five forces
IO literature has inspired Michael Porter and his five forces model of firm’s competitive environment. • Extent and intensity of competition • Threat of entrants • Threat of substitute products • Power of buyers • Power of suppliers
Bain-type IO vs. neoclassical view
Bain-Type IO allows for more heterogeneity among firms.
• Neo-classical view: in equilibrium no persistent above-normal profits
exist
• BTIO: persistent above-normal profits are possible even in the long run
• Heterogeneity of firms with respect to
• firm size
• side of the entry barrier (incumbent / entrant)
• market shares
Schumpeter’s response - Author?
Joseph Alois Schumpeter
Austrian economist (from 1939 US
citizen); From 1932 professor at Harvard; Contributions to economic development, innovation, economic history, business cycles, evolutionary theory …
Most influential heterodox economist
Teacher of N. Georgescu-Roegen, J. K. Galbraith, R. Solow, J. Bain.
Schumpeter’s response - Pt. 1
Schumpeter assumes that the purpose of the (successful) firm is to
identify and realize opportunities.
• Seizing opportunities (successfully) will
• generate competitive advantage
• render rivals obsolete
Schumpeter’s response - Pt. 2
- Schumpeter’s response can be seen as a fundamental critique on prior schools’ assessment of the important issues.
- Social value cannot be assessed by a static view
- Dynamic perspective (dynamic efficiency has to be considered)
- Schumpeter claims that the economy has to be considered as an evolutionary process.
- It is novelty (also new combinations) that drive the economy.
- Essential question here:
- Where does novelty come from?
Sources of novelty - two Schumpeterian views:
- Schumpeter Mark I (Schumpeter, 1912)
- creative destruction
- easy entry
- fundamental role of the entrepreneur (=small firm)
- Schumpeter Mark II (Schumpeter, 1942)
- creative accumulation
- large established organizations
- barriers to entry for entrepreneurs (sometimes created by the incumbents)
- Today both ideas seem to be complementary.
Schumpeter’s response - Pt. 3
In the second line of reasoning Schumpeter (Mark II) connects market
power to the firm’s ability to
accumulate knowledge
generate novelty
• Firms with monopoly power have more incentives to go for radical (game
changing) innovations.
ex ante market power ⇒ provides resources to pursue the risky efforts
ex post market power ⇒ incentives to pursue the risky efforts
Baumol on innovations importance
„…virtually all of the economic growth that has occurred since the eighteenth century is ultimately
attributable to innovation…under capitalism, innovative activity … becomes mandatory, a life-and death matter for the firm and innovation has replaced price as the name of the game in a number of important industries.“
