11W

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Technology, R&D, and Efficiency

11W-2LO1

• New and better products

• Better ways of producing and distributing those products

• Occurs over the very long run

• Incentive - the pursuit of profits

Invention, Innovation and Diffusion

11W-3

Short Run

• No change in technology, plant or equipment

Long Run

• No change in technology

Very Long Run

• Technology changes by R&D

LO1

Invention, Innovation and Diffusion

11W-4

Invention, Innovation and Diffusion

• Invention – New product or process

• Based on scientific knowledge

• Patent protection

• Innovation

• Product or process innovation

• Can’t be patented

• Diffusion – Spread of innovation through imitation or copying

LO1

11W-5

R&D Expenditures

AppliedResearch

(invention)20%

Developmentinnovation and

imitation75%

BasicResearch

5%

Science Resource Statistics , National Science Foundation www.nsf.gov.

LO2

11W-6

Modern View of Technological Advance

• Capitalism – driving force

• Profits – incentive

• Rivalry among firms – cause

• Starts from within the economy

• Internal to capitalism

• Old view – A random event from outside the economy

LO3

11W-7

Role of Entrepreneurs

• Initiator, innovator and risk bearer

• Other innovators

• Forming start-ups

• Innovating within existing firms

• Anticipating the future

• Exploiting university and government scientific research

LO3

11W-8

A Firm’s Optimal Amount of R&D• Marginal benefit and marginal cost

• Interest rate cost of funds

• Bank loans

• Bonds

• Retained earnings

• Venture capital

• Personal savings

• Interest rate cost of funds

• Expected rate of returnLO3

11W-9

• Expected Rate of Return – r

• Marginal benefit from R&D

• Slopes downward – diminishing returns for R&D expenditures

• Optimal vs. affordable R&D

• Expected not guaranteed returns

• Adjustments

LO4

A Firm’s Optimal Amount of R&D

11W-10

A Firm’s Optimal Amount of R&D

20

16

12

8

4

0 20 40 60 80 100

Inte

rest

Rat

e, i

(Per

cen

t)

R&D Expenditures (Millions of Dollars)

i

Interest-rate cost-of-funds curve

R&DMillions

$10

20

30

40

50

60

70

80

Interest-Rate Cost of Funds,

%

8

8

8

8

8

8

8

8

LO3

11W-11

A Firm’s Optimal Amount of R&D

20

16

12

8

4

0 20 40 60 80 100

Exp

ecte

d R

ate

of

Ret

urn

, r

(Per

cen

t)

r

Expected-rate-of-return curve

R&DMillions

$10

20

30

40

50

60

70

80

Expectedrate of

return, %

18

16

14

12

10

8

6

4

R&D Expenditures (Millions of Dollars)

LO3

11W-12

20

16

12

8

4

0 20 40 60 80 100

R&D Expenditures (Millions of Dollars)

Expectedrate of

return, %

R&DMillions

InterestRate

cost offunds, %

18

16

14

12

10

8

6

4

$10

20

30

40

50

60

70

80

8

8

8

8

8

8

8 Exp

ecte

d R

ate

of

Ret

urn

, r, a

nd

In

tere

st R

ate,

i (P

erce

nt)

r = i

LO3

A Firm’s Optimal Amount of R&D

11W-13

Increased Profit via Innovation

• Increased revenue via product innovation

• Importance of price

• Unsuccessful new products

• Product improvements

• Reduced cost through product innovation

LO4

11W-14

Product A Price=$1

Plot Points to Create Graph…

Product B Price= $2 New Product C Price= $4

Utility Maximization with the Introduction of a New Product (Income = $10)

Unit of Product

Marginal Utility, Utils

Marginal Utility per Dollar(MU/Price)

Marginal Utility, Utils

Marginal Utility per Dollar, MU/Price)

Marginal Utility, Utils

Marginal Utility per Dollar, MU/Price)

First 10 10/1=10 24 24/2=12 52 52/4=13

Second 8 8/1=8 20 20/2=10 48 48/4=12

Third 7 7/1=7 18 18/2=9 44 44/4=11

Fourth 6 6/1=6 16 16/2=8 36 36/4=9

Fifth 5 5/1=5 12 12/2=6 32 32/4=8

With $10 and choice of A and B(2A, 4B)

With $10 and choice of A, B or C (1B, 2C)

Increased Profit via Innovation

LO4

11W-15

To

tal

Pro

du

ct

Ave

rag

e T

ota

l C

ost

Units of Labor Units of Output

2500

2000

1000

TP1

TP2

ATC1

ATC2

2000 2500

$5

0

4

0

Upward shift of thetotal product curve

Downward shift of the average total cost curve

Increased Profit via Innovation

LO4

11W-16

Imitation and R&D Incentives• Imitation problem

• Fast-second strategy

• Benefits of being first

• Patents

• Copyrights and trademarks

• Brand-name recognition

• Trade secrets and learning by doing

• Time lags

• Profitable buyouts

LO5

11W-17

Role of Market Structure

• Pure competition

• Incentive to innovate, but rate of return is low

• Monopolistic competition

• Incentive to differentiate, but profits are temporary

LO5

11W-18

Role of Market Structure

• Oligopoly• Large size• Ability to finance R&D • Barriers to entry

• Can foster R&D• Complacency is a negative

• Pure monopoly• Little incentive to innovate

• Due to strong barriers to entry protecting profits

LO5

11W-19

Inverted U Theory of R & DR

&D

Ex

pe

nd

itu

re a

s a

P

erc

en

tag

e o

f S

ale

s

Concentration Ratio (Percent)

More Competition Less Competition

A “loose” oligopoly supports the optimum R&D spending

0 25 50 75 100

LO5

11W-20

Technological Advance and Efficiency

• Productive efficiency

• Increasing productivity of inputs

• Allocative efficiency

• A more-preferred mix of goods and services

• Creative destruction

LO6