Industrial Organization and Economics of Innovation

JSBE, Fall 2010

Tuomas Takalowww.takalo.netCC: By-Sa-Nc

Outline of the Course

• Part I: Introduction to Industrial Organization (IO)

– Self-study using, e.g., Luís Cabral’s book “Introduction to IO”, MIT Press, 2000

– Pre-exam: Home assignments 1 and 2

• Part II: Economics of Innovation

– Lectures

– Suzanne Scotchmer’s book “Innovation and Incentives”, MIT Press, 2004

– Other material suggested by the lecturers

Outline of Part II, Economics of Innovation

• Tuomas Takalo, SP&JSBE, 5 lectures: – “Innovation and Intellectual property (IP)”

• Heli Koski, ETLA, 2 lectures, 28.10– “Diffusion of Innovations”– “Diffusion of Innovations”

• Tanja Tanayama, VTV, 2 lectures, 1-2.11– “Technology Policy and Public Funding of R&D”

• Pekka Sääskilahti, Nokia, 2 lectures, 30.11 – “Management of Innovation”

Outline of Takalo’s Lectures “Innovation and IP”

1. Basic Economics of Innovation and IP

2. Basic IP Law for Economists and Business People

3. Designing Optimal IP Policy3. Designing Optimal IP Policy

4. Competition Policy, Standardization, and IP

5. Basics of Corporate IP Management

Course Requirements

• To pass the course the student must get enough scores from the home assignments and the exam (if there is one)

– Home assignments have the total weight of 0.2 and the exam 0.8

– Exam questions will be easier than home assignment 2.

Contacts

• Practical and administrative issues – heikki.lehkonen@jyu.fi

• Course substance• Course substance– tuomas.takalo@gmail.com

Economics of Innovation JSBE, Fall 2010

Lecture 1“Basic Economics of Innovation and Intellectual Prop erty”

- Scotchmer, Ch. 2 & Cabral, Ch. 16 -

7

Tuomas Takalo, www.takalo.net

CC: By-Nc-Sa

Oct 27, 2010

The Big Picture

• What is primitive in the economy?

• Real output grew very fast in the 20th century

– Why now? Why not before?

– What caused it?

• Why are we interested in GDP growth?

GDP p.c. in 1900 and 2001 and average growth rate

1990 International Geary -Khamis dollars

15 000

20 000

25 000

30 000

GK

$

2,00

2,50

3,00

3,50

0

5 000

10 000

15 000

Aust r

iaBelg

iumCan

ada

Denmar

kFinl

and

France

German

y

Italy

Japa

nNeth

erlan

dsSwed

enSwitz

erlan

d UK

USABan

glades

hInd

iaSou

th K

o rea

Argen

t ina

Mexic

o

GK

$

0,00

0,50

1,00

1,50

%

1900 2001 AGR (%)

GDP and Well-beingGDP/capita, 1999 US$

25,000

30,000

35,000

40,000

45,000Luxembourg

USA

DenmarkNorway

IcelandSwitzerlandCanada

Source: TEKES

0,000

5,000

10,000

15,000

20,000

25,000

50,0 52,5 55,0 57,5 60,0 62,5 65,0

FINLANDDenmark

Germany

SwedenAustria

Canada

50.0 52.5 55.0 57.5 60.0 62.5 65.0Well-being

Why Do Economies Grow?

• Up to the 50s, people thought: GDP=F(K, L)– K=capital, L=labor

• So ∆GDP = FK∆K+ FL∆L

• Data: ∆K & ∆L explain only a small fraction of ∆GDP! (Abramovitch 56, Solow, 1957)

• What is ∆GDP – FK∆K- FL∆L?

Why Do Economies Grow?

• Answer: Technological progress

• I.e., GDP=F(K, L, T)– K=capital, L=labour, T=Technological progress

• Current estimates of the importance of ∆T on ∆GDP:– 40-75%

GDP and Innovative Activity

120

140

160

180

200

USA

SwedenNetherlands

FinlandDenmarkAustria

Switzerland

Belgium

Ireland

Norway

Iceland

GDP/capita 2007 , EU 27 = 100

0

20

40

60

80

100

120

0,0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8

FranceSpainFinland

Estonia

Great Britain

Belgium

SloveniaItaly

LithuaniaHungary

CzechiaPortugal

Japan

RomaniaBulgaria

Greece

Latvia

Slovakia

EU 27

Poland

Germany

Innovation-index 20070.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Source: TEKES

Why Do Technologies Progress?

1. Production of new arts, knowledge & innovations ≈innovative activity

– R&D investments, basic research, education etc

2. Diffusion of existing arts, knowledge, innovations2. Diffusion of existing arts, knowledge, innovations

Why Does Innovation Policy and Management Matter?

• Knowledge is a public good – It is non-excludable and non-rival

• like traffic light, national defense, clean air etc– in other words, it is hard to prevent others using it

once available (non-excludability)once available (non-excludability)– it does not wear out (non-rivalry) ->society does not

want prevent others from using it once available

-> Markets for knowledge creation and diffusion likely to fail

Non-Excludability- Creation of Incentives Ex Ante

• Creation of knowledge requires effort & investments of various degrees

• If no excludability, a free-riding possibility emerges, why would any be one willing to invest? would any be one willing to invest?

– > too little innovation -> too little growth

A Game Theoretic Example

• suppose it costs 1000.000€ to develop a new product• MC of production = 50€• 100.000 buyers• the innovator needs to get at least 60€ per product

[100.000*(60-50)-1000.000=0] to break-even [100.000*(60-50)-1000.000=0] to break-even • suppose at least one other firm with an identical

production technology can enter • suppose that the innovation is easy to copy, i.e.,

imitation/duplication cost Š0ۥ assume Bertrand competition

Solution

• if the innovator invests, the rival will enter, and the firms will engage in fierce price competition

• in the competitive equilibrium the price will be 50€

• both firms make zero profits

• no incentive to invest in the first place!

• this the essence of the appropriability problem (Arrow, 62)

Digression: Home Assignment 1

• Let us suppose that the two firms (innovator and imitator) will encounter a cost shock that will double their marginal costs from 50€ to 100€

• What will happen to the equilibrium price?• What will happen to the equilibrium price?

• The new equilibrium price is 100 € so the price level doubles, too (a 100% increase).

• With intense competition, firms will pass all their cost shocks to consumers

Non-Rivalry- Diffusion of Innovations Ex Post

• Once knowledge is created it is waste to restrict its use– It does not wear out– Consumption by one does not restrict the

consumption of another

• Widespread notion that knowledge should be a publicly accessible good

• But if new knowledge becomes public fast, why would anyone want to invest to create it?

Need for Innovation Policy

1) Economic growth arises from technological progress

2) Technological progress arises from the creation of new knowledge (arts&innovations) and its diffusion

3) Knowledge is public good and markets for the creation and diffusion of knowledge are likely to fail

Need for Corporate Innovation Management

1) Competitive advantage of corporations arises fromA) the creation of new knowledge and innovationsB) from efficient adoption and trading of knowledge and

innovations

2) Cashing new innovations and trading them difficult because of the non-excludability and non-rivalry problems

3) Fast adoption difficult because innovation management of rivals!

Major Tools of Innovation Policy

1. Intellectual property (IP)

2. Public Production and Procurement

3. Public R&D Funding3. Public R&D Funding

4. Prizes and Contests

Introduction to the Economics of IP

24

“Era of Intellectual Capitalism”

• “IPRs (e.g. patents, copyrights, trade secrets) are everywhere. E.g. almost daily in the FT, HS etc

• Business, political, social and moral issue

“conceptualization (of GDP) is irreversibly increasing the “conceptualization (of GDP) is irreversibly increasing the emphasis on the protection of IPRs”

- Alain Greenspan -

Business Issues

• IP management crucial for success and failures of corporations

– IBM received 3622 US patents 2006, Canon 2427, Microsoft 1614, Nokia 810, Qualcomm 399...

– IP Business Models: Qualcomm, Apple iTunes, Intellectual Ventures, MySQL

– The use of IPRs have led to major changes in corporate strategy: Microsoft, Sun, HP, Qualcomm, Nokia..

Political and Social Issues

• Copyright issues in Finland & EU

• Software & business method patents (EU & USA)

• Industrialized v. developing countries

• Moral issues: patentability of genes, algorithms etc

• Many argue that the whole IP system should be abolished

– Boldrin and Levine

-> New political parties

Reasons for the Development

1) Economic science

• Cf. the Need for Innovation Policy – slide

Reasons for the Development

2) Technological progress itself: digitalization

• Knowledge as an economic commodity: market for technology

• IP renders knowledge tradable commodity

-> Specialization in knowledge production-> Specialization in knowledge production

• Technological changes that have undermined IP protection

Reasons for the Development

2) –> Changes in corporate IP management

1&2)-> Legal and administrative changes that strengthened the IP protection world wide over the last decades

-> movements against strong IPRs -> movements against strong IPRs

Some General Legal Issues

• IP legislation comprises of a variety laws

• International dimension

– US vs. Europe (rest of the world)

• Details complicated – basics simple

• Intellectual property ≠ real (tangible) property

Some General Legal Issues

IPRs are exclusive rights that can be used (to try) to forbid

others

• Without permission one cannot commercially use the subject (or a very similar subject) protected by an IPR

Limited duration

Infringement can lead to injunction/prohibition &

compensation

Patent is the gold standard of IPRs

• Strong protection but requires disclosure

Intellectual property rightsIntellectual property rightsIntellectual property rightsIntellectual property rights

Overview of IPRs: Economics

33

Protection Protection Protection Protection

of innovationsof innovationsof innovationsof innovations

(patents, (patents, (patents, (patents,

copyrights etccopyrights etccopyrights etccopyrights etc)

Trade secretTrade secretTrade secretTrade secret

(secrecy)(secrecy)(secrecy)(secrecy)

Identification marksIdentification marksIdentification marksIdentification marks

Economic Foundations of IP

• Market failure in the markets for knowledge

• As usually, the source of market failure is that the property rights are not well defined

• A straightforward solution: define property rights on knowledge

• A straightforward solution: define property rights on knowledge

• the rise of IPRs inherent to the rise of capitalism

– e.g., the first modern IPRs introduced in large scales in medieval city-states (e.g. Venice)

Reward Theory of IP

• seeks to mitigate the non-excludability problem

• unprotected innovations are easy to imitate

• IPRs needed to provide the right (to try) to exclude others others

• the right to exclude is a source for market power

• market power boosts the incentive to innovate

Disclosure/Contract Theory of IP

• seeks to mitigate the non-rivalry problem

• in the absence of IP protection, innovations are kept in secret

• to induce disclosure & avoid unnecessary duplication of innovation costs, a temporary “monopoly” right to

• to induce disclosure & avoid unnecessary duplication of innovation costs, a temporary “monopoly” right to innovation

• “patents as social contracts”:

– innovator discloses the details how to make the innovation and gets a temporary property right in return

Fundamental Tradeoff of IP

• Ex ante, IPRs provide incentive to innovate

• Ex post, they restrict the use of inventions

⇒ Need for a balance

Welfare

38

Strength of IPRs

Ex post problem

• Once knowledge is created it is waste to restrict its use

• Widespread notion that knowledge should be a publicly accessible good

• But IPRs by definition restrict the use• But IPRs by definition restrict the use

• It is also the major defect of IP compared with other

institutions of supporting innovation

P (price)

Demand p(Q)=a-Q

“willingness-to-pay”Pmax=a

Size of the

u(Q)=(representative) consumer’s utility

40Q (quantity) or # of consumers

Size of the market or

u(Qmax)

Qmax

P (price)

MC

Demand p(Q)=a-Q

“willingness-to-pay”

Competitive market for “tangible” goods

CS=W

Pmax=a

41Q (quantity) or # of consumers

MC

Q*

P*

In a competitive market for tangible (excludable, rival) goods

• Producer surplus / (ex post) profits (PS) = (P*-MC)Q*=0

• Consumer surplus (CS) = (a-P*)Q*/2= Q*2/2

• Social Welfare (W)= PS+CS=CS=(a-P*)Q*/2= Q*2/2

42

Competitive markets are efficient since

• The good goes to the ones who value it most

• Price equals the opportunity cost of resources required to

prodice the good (P*=MC)

i.e., the “indivisible hand” works

43

P

MC

P(Q)

Market for non-proprietary information good- MC of production/duplication ≈ 0

CSc=Wc

Pmax=a

44

Q

MC

Q*=Qmax=aas P(Q)=a-Q

P*=0

In a market for non-proprietary information good (non-excludable, non-rival)

• P*=MC=0

PSc (little c stands for competitive) = (P*-MC)Q*=0

CSc = (a-P*)Q*/2=a2/2

45

Wc = PSc+CSc=CSc=a2/2

• A competitive market for non-proprietary information good is efficient like any other competitive market

• the ex post market!

P P(Q)

Market for proprietary information goods

a

CSp

46

QQm

Pm

MC

a=Qmax

PSpDWL

In a market for a proprietary information good (excludable, non-rival)

PSp (little p stands for proprietary) = (Pm-MC)Qm= PmQm

Since the owner of the IP maximizes its profit:

Pm=a/2 → Qm=a/2 → PSp=a2/4 >0=PSc

47

CSp = (a-Pm)Qm/2=(Qm)2/2 = a2/8 < a2/2 = CSc

Wp= PSp+CSp=PmQm+(a-Pm)Qm/2= a2/4+a2/8 = 3a2/8< a2/2=Wc

Wc-Wp=a2/2-3a2/8=a2/8=DWL

DWL=Dead-weight loss due to proprietary pricing

• A market for a proprietary information good is inefficient due to market power of the IP owner

• DWL is the major defect of the IP as a technology policy tool

• the larger the size of the market (a), the larger is the DWL

48

Ex ante (approbriability) problem

• There is no incentive to innovate unless PS>0

• E.g., if the cost of innovation is KKKK, and 0<KKKK<PSp, the information good is created under the proprietary system but not in the competitive system

Emergence of the Fundamental Tradeoff

• IP is need to make PSp>0

• But if PSp>0, also DWL>0

That is,That is,

• If no IPRs or weak IPRs, there is little innovation

• If strong IPRs, there is price of innovations is too high and their use is restricted

⇒ need for a balance

Political Economy of IP

• Striking balance difficult in theory and in practice

• In a “closed” economy:

– innovators/IPholders want to max PSp– innovators/IPholders want to max PSp

– users want to max CS

– since users more dispersed than IP holders, pol. economy predicts

• IPRs too strong

• the emergence of new parties to protect users

Political Economy of IP

• In a small “open” economy:

– most of the CS goes abroad, policy makers should only care of PSp

– however, if the rest of the world have strong IPRs, the small open economy can free ride

– however, if the rest of the world have strong IPRs, the small open economy can free ride

->pol. economy predicts that IPRs too weak especially in areas where it does not innovate

Political Economy of IP

• Tensions intensified trough history after major technological breakthrough

– e.g., the antipatent movement of the end of 1800 century, compare with the free software movement

• In essence, there is nothing new in the current • In essence, there is nothing new in the current situation

Political Economy of IP

• The current strong IP/ “Intellectual Capitalism” era is rather young, about 30 years

• The question of our time: Does knowledge economy need need IP?

• In essence, would the incentive to innovate be • In essence, would the incentive to innovate be sufficiently high or even higher without IP?

• Does not go well in the traditional left-right political division

Welfare

55

Strength of IPRs

Rate of innovation

56

Strength of IPRs

IP as an Innovation Policy Tool

• IP is not an ideal incentive mechanism. Nor are the others (e.g. public funding, production, prizes)

• The other mechanisms seems to be better in solving the ex post problem

– IP almost by definition restricts the use of – IP almost by definition restricts the use of innovations (e.g. DWL)

Virtues of IP

1. Only the users pay the innovation investments

⇒ all inventions funded by IP create Pareto-improvements

• DWL could be reduced or even eliminated, if the IP holder would be able to price discriminate

• Some form of price discrimination is possible even with information goods

Virtues of IP

2. Decentralization

• Firms/innovators have better knowledge what should be invented or what is feasible to invent than the government

• private value of innovations under IP correlates with • private value of innovations under IP correlates with social value of innovations

Open Questions in Innovation Policy

• Is it optimal to combine the mechanisms, e.g., why publicly funded innovations are also protected by IP?

• Is IP the best system?

• Is it possible to design the other systems better so that we can get rid off IP? Come up with a new

• Is it possible to design the other systems better so that we can get rid off IP? Come up with a new mechanism?

Open Questions in IP Policy

• Is it possible to design IP better?

• Designing IP so that it does not restrict use (minimizes DWL) while providing the incentive to innovate

– Another major reason for the patent institution is disclosure i.e. spreading of innovations

– Another major reason for the patent institution is disclosure i.e. spreading of innovations

• If IP is the best, are there too many or too few forms of IPRs?

– Do we need more sui generis IPRs (industry or even innovation specific IPRs)?