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Drivers of Innovation
The distribution of innovative activity follows certain incentives.
Costs and Benefits
Economists interpret innovative activity through a structural cost-benefit lens. Assuming all other factors are equal, the actor who stands to gain the most financial benefit, or the actor who possesses the lowest cost of implementation, is statistically the most likely to execute an innovation. This is the cost-benefit logic.
Market Structure
The Schumpeter-Arrow model represents a foundational debate over whether market monopolies or competitive markets are more conducive to innovation. Even Schumpeter himself argues in 1912 (under the influence of the theory of economic development) that entrepreneurs and new firms, therefore fragmented markets, drive innovation; whereas in 1942 (during the divide of capitalism and socialism) he argues that large firms with some monopoly power drive innovation.
Efficiency Effect
If the innovation is only slightly better than existing products, it’s more attractive to remain the only player in a monopoly than the second player in a duopoly.
Cannibalization Effect
If an innovation is radical and replaces existing products, an existing firm would lose profits from existing products by innovating.
However, empirical studies support that drastic innovations often come from new entrants, not from incumbents.
Arrow: Large Firms Don’t Risk Themselves
The basic neoclassical model (Arrow, 1962) argues that monopolies have less incentive to innovate because they would cannibalize their current revenue stream from the old technology with a new one.
In contrast, a firm operating in perfect competition makes zero economic profit ex-ante because prices are driven down to marginal cost (). They have nothing to lose. By innovating, they leap from zero profit to an exclusive, highly profitable ex-post monopoly.
Social Planner
A social planner is a hypothetical decision-maker who seeks to maximize overall social welfare, rather than individual profit. In the context of innovation, a social planner would aim to allocate resources in a way that maximizes the total benefits of innovation for society as a whole, rather than just for individual firms, and therefore innovate more.
Schumpeter: Large Firms Have More Resources
Schumpeter (1942) argues that large firms have more resources to invest in R&D, can better absorb the risks of innovation, and can more effectively commercialize new products. They also have more market power to capture the returns from innovation. Therefore, they are more likely to innovate than smaller firms.
Liabilities of Newness
New firms face “liabilities of newness,” which include lack of established relationships with suppliers and customers, limited access to resources, a lack of experience in managing growth, and no buffer for survival. These factors can make it more difficult for new firms to innovate and succeed in the market.
In contrast, small firms are more open, flexible with their business plan, can hire better matches for the task, and have, on average, younger employees.
Disruptive Innovation among Incumbents
Clayton Chistensen (1997) explains why in some industries, leading firms manage most innovation. Often, these innovations are technologically straightforward and do not satisfy customers in the established markets. However, they are sold to niche/new markets, until both the old and new technology outperform their market needs and the innovation replaces the old technology.
In this case, incumbents are more likely to innovate because they have the resources and market power to capture the returns from innovation, and they are less likely to be disrupted by new entrants.
However, when incumbents focus too much on existing customers and markets, they may miss out on disruptive innovations that could eventually replace their existing products. This is known as the “innovator’s dilemma,” where successful companies can fail by doing everything “right” because they are too focused on their current customers and markets.
Is Uber Disruptive Innovation?
Disruption is a process, and disruptors often build a different business model than incumbents. According to the lecture, Uber is not disruptive innovation because:
- Disruptive innovations originate in low-end or new-market footholds, but Uber entered the mainstream market first, then expanded into niches.
- Disruptive innovations have initially inferior product performances, but Uber’s service was often superior to traditional taxis.
Example Exam Questions
Assume that the monopolist InnovaTUM faces the demand curve 𝑝 = 100 − 𝑞, where 𝑞 is the number of units produced and sold at price 𝑝. The constant marginal cost of production are 𝑐 = 75. Fixed costs are zero.
- Easy: Calculate the quantity , price , and profit that InnovaTUM will realize as a monopolist.
- Still pretty easy: The R&D department introduces a radical innovation which allows InnovaTUM to reduce the marginal cost of production to . Calculate the quantity , price , and profit in the ex-post monopoly, assuming the same demand curve as in the ex-ante monopoly . How high is the net gain from the innovation?
- A little tougher: To what level would need to decrease so that we would speak of radical innovation in the Arrow sense? What is the maximum fixed cost such an innovation may cost InnovaTUM to be economically viable?