Implications of Monopoly on Innovation

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Implications of Monopoly on Innovation: A Brief Review - Kruti Dholakia, Email: Kruti@utdallas.edu , Date Submitted: 29 November 2004. (Paper Written for Dr. Hicks 9 Class 3 ECO 6345 Innovation Dynamics and Industry Change) Abstract This paper tries to bring together the basic explanation of monopolies and Schumpeterian hypothesis of type and size of firm stimulating innovation by taking into account some literature that relates these two.

It is a brief literature synthesis and sets grounds for future empirical research to test the Schumpeterian hypotheses. Introduction The purpose of this research is to briefly survey the literature that explores the Schumpeterian concept of 8process of creative destruction 9, which suggests that product innovation is oriented towards providing substitutes and thereby reducing monopoly power. The literature analysis presented by Reinganum (1984) is the primary source used in writing the following paper.

The hypothesis of the presented literature review is that monopoly has implications on innovation that are far reaching in terms of optimal social output. Since the scope of the current paper is limited, the reviewed literature, while varied in methodology, is reasonably uniform in terms of outcomes. Before we delve into a detailed literature comparison, it would be helpful to paint a ... more. less.

broad picture of monopoly firms, their impact on markets and their unique characteristics in terms of input-usage and outputs. The third section comprises of a brief introduction to the Schumpeterian hypothesis and topics that branch out of these. The fourth section of the paper aims at comparing and contrasting some dominating literature that either supports or opposes our hypothesis and the last section of this paper provides conclusions based on the results obtained in the literature analysis. Monopoly and its Characteristics Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Producers have substantial amount of monopoly power for a number of products. These are called 8near 9 monopolies. The characteristics of pure monopoly are as follows (McConnell and Brue 2004): 1. Single seller firm comprises the entire industry. 2. There are no close substitutes for product available in the market. 3. The firm is a 8price maker 9 and has considerable control over the price because it can control the quantity supplied, and has the ability to fix the price of the good in the market. 4. There are barriers to entry in the industry by other firms. There is a limit imposed on competition because monopolies operate at economies of scale. Lowest unit costs and lowest unit prices for consumers depend on existence of small number of large firms or only one firm. A very large firm with a large market share is most efficient and new firms cannot afford to start up industries with economies of scale. Legal barriers to entry exist in the form of patents and licenses. 5. A monopolist may or may not engage in non-price competition. Depending on the nature of its product (durable good, non-durable good, substitutable good), a monopolist may decide to advertise to increase demand by spreading information. A graph showing the price-setting behavior of monopolies is as shown here in Figure 1. Figure 1. Monopoly Price Determination The quantity demanded in the market for the product is at the point where the Marginal Cost (MC) curve intersects the Demand Curve (D). Since the Marginal Revenue (MR) function of the firm is as shown in the adjoining figure, and MR = MC is the profit maximizing rule, the firm produces the quantity determined at this level which is less than the social optimum. Monopolies have the price determination or price discrimination rights; the price is set at the level on the Demand Curve for the quantity of production determined by the monopoly. This price is higher than the socially optimal price. Thus, monopolies have incentives to make pure profits. Schumpeterian Hypothesis There are many versions of the Schumpeterian hypothesis that contain several different assertions, but the focus of this paper is the argument that monopoly power stimulates innovative activity. Both, the Solow growth model and the neoclassical model of capital accumulation predict that, in stationary equilibrium, the rate of growth is equal to the exogenous rate of technological progress. Schumpeterian literature on endogenous growth implies that in stationary equilibrium, the rate of growth is constant and equal to the endogenous rate of technological progress (Corriveau 1998). However, before we consider technological progress in the context of monopoly, it is necessary to distinguish between anticipated and actual monopoly power (Geroski 1990). Anticipated monopoly power refers to an innovator 9s ability to prevent imitation and thereby cultivate the full benefits of its research (Kamien and Schwartz 1982, p. 27). Thus, the part of Schumpeterian hypothesis that asserts that innovation occurs only when some degree of expected post-innovation monopoly exists is relatively uncontroversial. The disputable aspects are the assertions about the effect of actual monopoly power (Geroski 1990). Actual monopoly can have a direct effect for level of post-invention reward and an indirect effect on size of post-innovation reward. Geroski (1990) continues the argument presented by Scherer (1980) by stating that the indirect effect of actual monopoly on innovative behavior, which arises whenever current monopoly power affects the likelihood of achieving a given degree of post-innovation monopoly power, is likely to be positive. The principle reason to anticipate this positive effect is that a current monopolist is likely to be well placed to erect barriers to future entry (Levin 1978). These barriers may be durable in protecting the monopolist in the future. When the results of future innovations complement innovations made by the monopolist, then the monopoly will gain more than its rivals will and, if necessary, will pre-empt rivals (Gilbert and Newberry 1982, Geroski 1990). Ben- Zion and Fixler (1981) give an empirical example of this pre-emptive behavior of monopoly. The following figure from their paper explains the decision-making involved in introducing a product that is either a close substitute or complement to the good produced by the monopoly. Figure 2. Schematic Diagram for Firm 9s Decision-Making Process Source: Ben-Zion and Fixler, 1981 . However, there are at least three reasons to expect a negative direct effect of monopoly on innovation, as described by Geroski (1990). The first is the absence of active competitive forces, which may allow behavioral disadvantages of monopoly to manifest. The second is that there is an increase in number of firms searching for an innovation, and hence there is an increase in the probability that it may be attained in some time t. Finally, incumbent monopolists will enjoy a lower net return from introducing a new innovation that displaces part of activities of the old one (Arrow 1962, Fellner 1951, Delbono and Denicolo 1991). The opportunity cost of innovation compounds the cost, which may arise if incumbents 9 capital stock is locked into a particular technology, and slows response of a monopolist to a new innovation promising a positive return of any given size (Geroski 1990). Thus, there are two effects of actual monopoly on innovative activity. The indirect effect is likely to be positive, and the direct effect may not be. Geroski (1990) presents an empirical model to cast light on the size and direction of the overall effect of actual monopoly on innovative activity by isolating and measuring the strength of each of these two effects taken separately. This empirical model does not successfully test the hypothesis that rivalry is inimical and monopoly is conducive to innovativeness. The conclusion of the tests is that role of rivalry in stimulating innovation is interesting but is apparently nowhere near as important as that of technological opportunity, which is a benefit that monopolies enjoy because of significant profits gained by past innovations. Another important contribution of Schumpeter is the concept of ccreative destruction d. This view states that in a capitalistic system, economic growth occurs through a process of 8creative destruction 9 whereby the 8old 9 industrial structure 3 its product, its process, or its organization 3 is continually changed by 8new 9 innovative industrial activity (Link 1980). The optimal allocation of entrepreneurial attention depends on the degree of this ccreative destruction d (Gifford 1992). Schumpeterian hypothesis is usually interpreted as implying a positive relationship between innovation and monopoly power with the concomitant above normal profits, or large firms are more than proportionately more innovative than small firms are (Nelson 1990). Nelson briefly describes the shortcomings of the proxies used for measuring innovative activity. Innovative activity has been measured using innovative inputs, such as R&D expenditures or the employment of scientific and engineering personnel, or innovative outputs, as represented by the number of patents, significant innovations, or sales of new products. Statistical tests of the Schumpeterian hypothesis have focused on two relationships: 1) between firm and innovative activity 2) Between market concentration and innovative activity. Kamien and Schwartz (1982) surveyed some statistical studies and concluded that the statistical evidence supporting Schumpeter 9s hypothesis is 8wanting 9, in general (Link 1980). An important note here is that the policy prescription of the Schumpeterian hypothesis is that antitrust enforcement needs to be lessened because of possible detrimental effects on technical change (Lunn 1982). Literature Synthesis A paper by Geroski and Pomroy (1990) traces the interaction between the role of market structure in the process of generating new innovations and the effect of innovation on market structure. The authors conclude that competition stimulates innovation and innovation increases the degree of competition in markets, both effects leading in principle to a steady rise in the rate of innovation and to a steady fall in market concentration over time (Geroski and Pomroy 1990). This indicates a tendency of the market to go towards monopoly. It is easy to understand this result when we consider that after an innovation is introduced, the firm that achieved it first has a desire to gain the awards in terms of profits associated with that innovation. Ben-Zion and Fixler (1981) present a similar reasoning in their paper. Yet another paper by Geroski (Geroski, Machin, and Reenen 1993) explores two questions. First, is the relationship between profits and innovative output similar to that which has been found between profits and research inputs or patent counts? Second, does the correlation between innovative output and profitability reflect transitory or permanent differences in performance between innovating and non-innovating firms? Some of the important implications of these questions are as follows: 1) Not all firms that introduce innovations do research and development 2) Most patents protect relatively minor innovations 3) Innovative output measures generate quite different estimates of the size of spillovers than innovative input measures do. 4) Superior performance of the firm is the product of the innovative process, which favorably affect a firm 9s market position. 5) Process of innovation transforms a firm, builds up its core competencies, and makes it quicker, more flexible, more adaptable, and more capable in handling market pressures than non-innovating firms. It can be extrapolated from these implications, that monopoly firms have the means to introduce new innovations through internal research and development funds, and morph into more adaptive market strategy-makers to generate future profits and create barriers for other firms to enter the market for the newly introduced good. Industries which experience rapid changes in technology or host numerous new faces, year in and year out, are likely to be those in which incumbents are under some pressure to perform well (Geroski 1989). The innovation, firm size, and growth of a centrally controlled organization are shown to depend on the allocation of entrepreneurial attention between maintaining current operations and innovating new products (Gifford 1992). The author argues that current projects are subject to possible obsolescence but new projects may or may not be successful. An optimal allocation of attention on current projects and new projects determines the optimal innovation, size, and growth of a centrally controlled organization. This optimal allocation implies that the firm 9s propensity to innovate depends on monopoly profits, firm size, technological opportunity, and degree of ccreative destruction d. Additionally, effects of monopoly profits on innovation depend on degree of obsolescence relative to technological opportunity. Firm size and monopoly profits have greater effect on innovation in markets with low technological opportunity (Baldwin and Scott 1987). If the degree of obsolescence is sufficiently low for a product, that is endurance of product is sufficiently high, then innovation increases with monopoly profits and deceases with firm size. Otherwise, rate of innovation is independent of market and firm characteristics (Gifford 1992). Thus, it is important to consider the degree of obsolescence when considering the Schumpeterian hypotheses of effects of monopoly profits and firm size on innovation. It is also important to note Gifford 9s (1992) result that innovative effort is more product-oriented than process-oriented in markets with high technological opportunity. Hausman (1988) states that price discrimination by a patent holder (monopolist) as a socially undesirable exploitation of monopoly power is an ongoing controversy. The author proceeds to test that welfare gains occur because price discrimination allows patent holders to open new markets and to achieve economies of scale of learning, and to achieve higher efficiency relative to other market mechanisms. Economic analysis of price discrimination emphasizes that price discrimination raises the patentee 9s profitability and misallocates resources among purchasers, causing a decrease in social welfare. Hausman (1988) argues that an optimal social policy for patents and monopoly will maximize the net social benefit of encouraging innovation while incurring monopoly misallocations. Thus, some amount of price discrimination appears to be an efficient way to provide an innovator with a profit reward, thereby increasing the Marshallian efficiency of the patent system. This could also lead to Pareto welfare improvements. Moschini and Lapan (1997) in their work on agriculture property rights and innovations also assert the same. The conclusion of Hausman 9s (1988) research is the causal notion that third-degree price discrimination is good for the monopolist but bad for the public is not true as a general proposition. Support for this conclusion is the result of Smith 9s (1974) research, which states that regulation can distort the innovational selections. In the case of the profit-maximizing firm subject to 8fair 9 return on investment regulation, the innovational choices will reinforce the static overcapitalization tendencies. Regulation on the allowed rate of return for utilities may impose costs on society in terms of inefficiency in resource utilization, but at any point in time, these costs may be inconsequential. The extent to which the regulated utilities are not vertically integrated into research and innovation, the control of the pattern of external R&D may provide scope for ameliorating the resource misallocative effects of regulation (Smith 1974). The discussion on innovations and innovative output raises the question about how to measure it. Lunn (1982) states that measuring innovative output is very difficult, resulting in a statistical focus on relationship between firm size and some measure of innovative inputs, arguing that inferences can be made concerning innovative output and firm size as long as the production of innovations is characterized by non-decreasing returns to scale. However, Lunn (1982) argues and concludes that knowledge of the relationship between firm size and innovative inputs fails to provide information concerning relationship between firm size and innovative output without detailed knowledge of the production function of innovation. Magat (1976) examines the effect of three forms of regulation (rate of return, ceiling-price, and markup) upon the rate and direction of technical advance selected by a profit-maximizing firm. A homothetic production function causes ceiling-price regulation to induce a faster rate of technical progress and faster than that which would result with markup regulation. Also, no support is offered for the conjecture (offered by some other authors that we are not considering in this literature synthesis) that technical advance causes an increase in discrepancy between resource allocations selected by a rate of return regulated firm and those chosen by an unregulated firm (Magat 1976). If estimates of scale economies and the growth rate of output are available, however, it is possible to 8correct 9 the estimated rate of productivity growth to obtain an estimate of the rate of technical change that may be used as an appropriate measure of dynamic efficiency in tests of the Schumpeterian hypothesis (Nelson 1997). An interesting question about invention and innovation raised by Waterson (1982) is the dilemma faced by an inventor outside the final product industry who has sole property rights in a new process for producing the given product, which is a discrete improvement over the old process. The inventor 9s dilemma is to decide to sell his property rights to a monopolist or a competitive industry, with an intention to make the greatest profit for him (or her!). If monopoly provides inventor with more profit, Waterson (1982) expects more invention in areas where user industries are monopolistic and swifter innovation of potentially widely applicable input inventions, ceteris paribus . All other things equal, the innovation would be more likely to be made first in the monopolistic industry. On a social concern, the increase in welfare consequent upon the innovation would be greater in the competitive industry than the similar monopolized industry. Conclusion Based on the above literature synthesis, it is possible to conclude that there is definitely a strong debate in the field of innovation and monopoly. There are people who oppose the Schumpeterian hypotheses because of the difficulties in proving the results empirically and people who support it by blaming the measures and assumptions used for statistically testing the hypotheses. The implications of this debate are far-reaching and stronger research designs may eliminate the doubts surrounding issues like estimation of 3 innovation outputs, the innovation production function, profit-maximizing behavior of firms, utility- maximizing behavior of consumers, etc. The result of our literature review is that monopoly definitely seems to have a strong impact on innovations in the product market, by providing significant rewards to inventors, having quicker innovative procedures, possessing ability and resources to create barriers to entry in the market, developing economies of scale, and making profits because of price discriminating behavior. References Arrow, K. 1962. Economic Welfare and the Allocation of Resources for Inventions. In Nelson, R. (Ed) The Rate and Direction of Inventive Activity . Princeton University Press, Princeton. Baldwin, W.L., and J.T. Scott. 1987. Market Structure and Technological Change. New York: Gordon and Breach Science Publishers. 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