Economics of Innovation, Environment & Society Course Outline PDF

ECONOMICS OF INNOVATION, ENVIROMENT AND SOCIETY 09/09/2024 The Instructors Team: 1st semester (Economics of Innovation) Professor: Francesca Lotti ([email protected]) TA: Gloria Di Caprera ([email protected] or [email protected]) 2nd semester (Environmental Economics) Professor: Edoardo Di Porto ([email protected]) TA: Matteo Targa ([email protected]) + Dimitri Zurstrassen (Bonus track - EU Industrial Policy in an era of Geoeconomic Competition) ([email protected]) + “Social” aspects covered along the course Office hours by appointment (email) Exam and grading (12 UFC): As mandatory, we will practice an ACTIVE LEARNING PATH, which means a bundle of lectures, flipped classroom, project works & active participation in class. Accordingly, EVALUATION will be active throughout the course Teamworking: you will perform some activities in team REMEMBER: If you miss both exams, you can decide whether to keep the continuous assessment grade or not in the first available session. After that you become a non-attending student Course overview: Innovation Innovation as an engine for growth; creative destruction and macro fluctuations Intellectual property & appropriation Innovation & competition Returns to innovation, technology diffusion Innovation policy & ecosystems Measurement issues (data analisis) Course overview: Environment Where are the market failures (a kind of market failure are the monopoly)? Public goods & externalities (like emissions are bad externality and so another kind of marker faliure) Policy instruments Agglomeration Federalism & international agreements Environmental migration The double dividend and the Porter hypothesis Measurement issues Course overview: Industrial policy States, Markets and activist Economic governance The evolution of industrial policies The interaction between competition & industrial policies The New EU Industrial Strategy: green & digital transition, national security Industrial policy & cohesion Pre-requisites: The topics about Industrial Economics you have to recall are: 1. Consumption and firms’ theory; 2. Competition, equilibrium and efficiency 3. Market failure, regulation and efficiency 4. Oligopoly 5. Collusion 6. Market structure and its evolution To help with this part use text book: Luis Cabral, Introduction to Industrial Organization. Part 1, part 2 and part 3 The topics of descriptive statistics we will be using are: 1. definition of sample and population; 2. classification of variables and graphical reresentations; 3. central tendency measurements; 4. variability measurements; 5. summary measurements; 6. correlation among variables; 7. linear regression. Any statistics book would do the job Key words: analysis, productivity, technical change, innovation, digital transition and industrial policies 11/09/2024 A NEW GROWTH PARADIGM (Lecture 1) (Ch.1 of AAB book) What is Creative Destruction? The Old and the New Creative destruction: better/new (creative) products brought to the market thanks to improvement and evolution of technologies completely replacing the existent standard, same customer needs, but at the same time you have a destruction because the new weeps away the old (≠ if old product and new coexist, it is not creative destruction) Es: Streaming vs CD (Netflix vs Blockbuster) Typewriter vs Computers Newspaper vs Online News Cash vs Crypto Digital Marketplaces vs Shops At the end, you will è Understand some of the great historical enigmas associated with the process of world growth, such as: Industrial take-off (development of some markets) Major technological waves (industrial revolutions) Secular stagnation (moments of no growth) The evolution of inequality (only a bit of inequality is good for the economy) Convergence and divergence across countries The middle-income trap Structural change (a production system move from an equilibrium to another) è Revisit the great debates over innovation and growth in developed nations: Can we foster innovation and creative destruction while at the same time protecting the environment and reducing inequality? Can we avoid creative destruction’s potentially detrimental effects on employment (creative disruption can be really bad for some groups of the society), health, and well-being? Must we fear the digital and artificial intelligence revolutions? (must we fear this evolution or go for it?) è Rethink the role of the state and civil society: What role can each of them play to stimulate innovation and creative destruction and thereby increase the wealth of nations? How can we protect citizens and the economy from the excesses of capitalism? Creative Destruction Creative destruction is the process (the intensity can change overtime) by which : - new innovations continually emerge and render existing technologies obsolete, - new firms continually arrive to compete with existing firms - new jobs and activities arise and replace existing jobs and activities. Creative destruction is the driving force of capitalism, ensuring its perpetual renewal and reproduction, but at the same time generating risks (it is a risk activity) and upheaval that must be managed and regulated. (there are some limits to creative destruction, the incumbents react to prevent the entry of new firms, es: lobbing) How do we measure the wealth of a nation? The preferred measure of the wealth of nations is per capita gross domestic product (GDP per capita). it is just one statistics, but it reflects many other dimensions. GDP may reflect some of the dimensions, but there are many others that the GDP does not consider To understand where we are going, we have to understand where we are coming from The Old growth paradigm Existing paradigms have proved inadequate, for both theoretical and empirical reasons (what you see doesn’t reflect the theory). The theoretical reason. Up to the late 1980s, it was the dominant theory of economic growth, the neoclassical model, was one of a growth process based on capital accumulation (Solow, 1956) (it was considered the only source of growth) - In a nutshell, the model describes an economy in which production requires capital, and where growth of GDP comes from increasing the stock of capital. What causes the stock of capital to grow? Households’ savings, which are presumed to be equal to a constant fraction of production (that is, of GDP). - All is well in this economy: more capital, financed by savings, increases GDP, which leads to more savings and therefore more capital, further increasing GDP, and so forth. - Is this true? -> In reality things doesn’t work like that, there are decreasing returns on producing solely with capital, so the increase of GDP will be smaller every time àNeed innovation to keep the economy growing The empirical reason. Neoclassical theory does not explain the determinants of long-term growth (growth potential). Even less does it enable to understand a whole set of enigmas related to growth, for example, why some nations grow more quickly than others, and why some nations converge to the levels of GDP per capita of the developed world and others remain far behind or stall along the way. This is why we need: The Paradigm of Creative Destruction The model of growth through creative destruction is also known as the Schumpeterian paradigm because it was inspired by three ideas put forward by the Austrian economist Joseph Schumpeter Main ingredients of innovation: 1. Innovation and the diffusion (without diffusion there is not innovation) of knowledge are at the heart of the growth process. 2. Innovation relies on incentives and protection of property rights. 3. Creative destruction: new innovations render former innovations obsolete. Growth by creative destruction sets the stage for a permanent conflict between the old and the new: it is the story of all incumbent firms, all the conglomerates, that perpetually attempt to block or delay the entry of new competitors in their sectors. Creative destruction creates a dilemma at the very heart of the growth process. Rents are necessary to reward innovation and thereby motivate innovators; … but yesterday’s innovators must not use their rents to impede new innovations. Schumpeter’s answer to this dilemma was that capitalism was condemned to fail because it is impossible to prevent incumbent firms from obstructing new innovations. Modern view: it is indeed possible to overcome this contradiction, in other words to regulate capitalism The reality of Creative Destrucion: patents Creative destruction is NOT an abstract concept. We can perceive it through the arrival of new products and new technologies, measured by the number of patents filed each year in a country or region. There is a positive correlation The reality of Creative Destrucion: firm dynamics (firm dynamics is another way to see creative destruction) Who creates jobs? Newborn firms are responsible for the new job creation Youngest firms exhibit stronger net job growth than long-established firms. But also they can be very risky: younger firms have a much higher exit rate than long-established firms (and they can fail). This is what we call “up or out” dynamics: each new generation of startups (the ones that go up) creates a large number of new jobs. Creative Destruction & GDP growth What is the relationship between creative destruction as measured by the creation and destruction of jobs or firms and creative destruction as measured by the number of new patents? There is a positive correlation between the two measures: on average, the American counties with the highest rates of job creation and destruction were also the counties that produced the most new patents. This correlation is largely due to the fact that the most innovative firms are the small, young firms that also create and destroy the most jobs. A New Landscape It gives CenterStage to cross-firm heterogeneity - Between incumbents and entrants - Between leaders and followers (tension between technological leaders and technological followers, if the distance is big there is no way for the followers to get close to the leaders and the economy freeze) - Between small and large firms (typically new firms are small and incumbents ar large) è These are the main ingredients that goes by the name of FIRM DYNAMICS, that is the heart of creative destruction A few growth enigmas 1. The industrial takeoff (he transition from stagnation to growth) 2. Secular stagnation 3. Middle-income trap 4. Competition & innovation 5. Inequality 1. The industrial take-off (Economic) Growth is a recent phenomenon: world per capita GDP was the same in the year 1000 as in the year 1. This world per capita GDP was only 53 percent higher in 1820 than it had been in the year 1000. The word is flat until the beginning of the 19th century The take-off started in 1820, first in the United Kingdom, then in France. The take-off in these two countries was of such magnitude that the average annual rate of growth jumped from 0.05 before 1820 to 0.5 percent from 1820 to 1870. And after that, global growth continued to accelerate, reaching approximately 3 percent between 1950 and 1973. How can we explain such a recent and sudden take-off of growth? Why did it take place in Europe and not in China, been made since the Middle Ages? More generally, what explains other transitions, such as from manufacturing to services, or from catch-up economies to innovation economies? The neoclassical model is silent on these questions. 2. Secular Stagnation In his presidential address to the American Economic Association in 1938, the economist Alvin Hansen explained that he believed the United States was doomed to long-term weak growth, a condition he dubbed “secular stagnation” (one of the biggest crisis ever) The country had just emerged from the Great Depression. More recently, the 2008 financial crisis led Lawrence Summers and other economists to revive the term secular stagnation to describe a situation they saw as similar to that portrayed by Hansen in 1938. à general and wide spread slowdown of economic activity and productivity Why has American growth fallen off since 2005 despite the information technology (IT) and artificial intelligence revolutions? Production function Made of 3 ingredients: capital (K), labour (L) and total factor productivity (it is a measure of efficiency, you became better and better every day, A) The effect of IT technologies coming in à it had an impact on the total factor productivity The growth rate of TFP for different group of industries IT producers (black line) This graph shows the importance of technology diffusion à it takes time between innovation and diffusion(sometime the GDP doesn’t grow) Another thing that started to emerge is the decline of labour share (the piece of pie that goes to workers vs the piece of pie that goes to firms) à the reason why it decline is because the profit shares increased (market power of the firms) Markup is been increasing overtime, the responsible for this growth is the reallocation component (within component, some firms become more profitable; net entry, the effect of the new firms entering and exiting the market; reallocation, movement of the sources between firms) à the increase in markup is explained mostly by the reallocation effect (firms with high markup became bigger overtime absorbing the resources in the economy) The paradigm of creative destruction suggests a more optimistic vision of the future First, the IT revolution fundamentally and permanently improved the technology of producing new ideas. Second, the process of globalization, contemporaneous with the IT wave, substantially increased the potential rewards of innovation (scale effect) and at the same time the potential cost of not innovating (competition effect). Accordingly, innovation has been accelerating both in quantity and in quality over recent decades. Why doesn’t this acceleration show up in the observed evolution of productivity growth? SUPPLEMENTAL MATERIALS TO READ ON YOUR OWN 3. The Middle-Income Trap In 1890, Argentina’s per capita GDP had reached 40% of that of the US, making it a middle- income country. Argentina maintained this status until the 1930s, without reducing the gap. But starting in the 1930s, Argentina’s productivity began to drop relative to that of the US. Why did the convergence of Argentina’s standard of living toward that of the United States stall and instead begin to retreat? è Growth Interruptions Neoclassical theory cannot explain such breaks in economic trends. In the neoclassical model, the growth rate declines progressively as capital accumulates, but without trend breaks. The explanation offered by the Schumpeterian theory of growth is that countries like Argentina had institutions or adopted policies favouring growth by accumulation of capital and economic catch-up—in particular a policy of import substitution… But they failed to adapt their institutions in order to transition to innovation economies 4. Competition and Growth One might think that everything that reduces profits, such as intense competition on product markets, would automatically decrease the incentive to innovate, and that more competition implies less innovation and therefore less growth. However, there is positive correlation between competition and innovation in a sector as well as between competition and productivity growth in that sector. What explains this paradoxical result? The neoclassical theory has little to say on this enigma, as it assumes perfect competition. The paradigm of creative destruction solves this enigma. 5. Inequality Over recent decades, income inequality has increased rapidly in developed countries, especially at the very top of the income scale. The share of the “top 1%” in total income has risen sharply. How can we explain this evolution? Why is it important to know that the increase in the share of income going to the top 1% results partly from innovation and not solely from income from real property rents and speculation? Different forces here: Innovation (by large incumbents) increases top income inequality Innovation (by small entrants) increases social mobility è Innovation does not increase broad inequality; Tax policy & redistribution Two Further Implications of the Paradigm of Creative Destruction Imitation vs. Frontier Innovation. There are two ways to generate productivity growth and technical progress. First, technological imitation makes it possible to adapt best practices in each sector of activity, in other words, to imitate what is happening at the technological frontier. Second, innovating at the frontier enables a firm that is already at the technological frontier to innovate relative to itself, since it has no one else to imitate. à this is true for firms, as well as countries The Environment and Directed Innovation. The problem with established firms is not solely that they try to prevent the entry of new, innovative firms. There is another problem relating to their conservatism regarding innovation and technical progress. A car manufacturer that has innovated in combustion engines in the past will tend to innovate in combustion engines in the future because that is where it excels. It will not spontaneously choose to innovate in electric vehicles. This phenomenon is called path dependence. State intervention, through a variety of instruments, is necessary to redirect firms to innovate in green technologies. 16/09/2024 INNOVATION AND INTELLECTUAL PROPERTY THE INNOVATION PROCESS (Lecture 2) Introduction From macro to micro Innovation widely seen as engine behind economic growth and improvements in standard of living. Objectives: - Maximize benefits from innovative activity - Mitigate costs of innovative activity Requires understanding of innovative process and how to manage it, both at the business and the economy-wide level Focus on innovations that have direct impact on economy, by increasing productivity or improving and expanding available goods and services But why study innovation? - How innovation contributes to economic growth - How does innovation process work? - What motivates innovators? - Choose innovation strategies to increase profits / defend against competitors - Design institutions and government policy Innovation and economic growth Only 1/2 to 2/3 of growth accounted for by increases in the physical capital stock and the education levels of workers. Remainder due to technical change which means greater output is obtained from the same inputs (gain of efficiency à ability of producing a bigger output with the same input). R&D investments explain the growth and the gain of efficency GDP of USA and UK started to grow with industrial revolution, China was flat (started to develop much later) Increased importance of R&D investment USA is the big player here China started later with an exponential growth (of investment in R&D, that determines also the size of the economy and so the growth of GDP) Government spending and private spending R&D intensity over time The USA was the most innovative country (now is les evident) Corea is the big player here with intensity growing overtime Also China has a good intensity Overview Innovation as source of competitive advantage and growth (but remember: R&D is not the only source of innovation) What affects incentives for innovation? How do firms appropriate the returns to innovation (revenues, money, profits)? How can innovation translate into competitive advantage? Objective of this course: gain understanding of technical change and the innovative process, its determinants and consequences. In particular: - Incentives for innovation - Source of strategic and competitive advantage for companies - Policy tools THE INNOVATION PROCESS Chapter overview Linear model and its critiques Science from technology Learning from doing and using Direction and types of innovation Innovation – a quasi-public good 4 insights about the innovation process: Although economic factors are important for an understanding of the rate (speed: how good you are in taking new products and process) and direction (where are you going/goals that you want to reach/where are you directing your efforts) of technical change, chance and unpredictability (es: came up of new technologies) are often seen in the process. Although innovation it is often modeled as a linear process from science to the end product (consumers), throughout the process of innovation there can be feedback from one stage to an earlier stage. Such feedback can be important to the eventual success of the innovation. Innovations frequently require a number of factors to come together before they are (innovation is) made (ecosystem of innovation); that is, the environment in which the innovation will come to life needs to have the necessary ingredients to make it effective, such as consumer demand for the innovation and the capabilities of necessary complementary products Although the relevant science (one of the most important ingredients of innovation) is often a precondition for an innovation, some innovations are made before the science that lies behind them is completely understood. Elements of innovation Invention: creation of the idea of how to do or make something (usually done by an individual, sometimes a small team of individuals); technical knowledge. “an increment in the set of total technical knowledge of a given society” (Mokyr 1992) à technical abilities to do things in a different way “prescription for a producible product or operable process so new as not to have been obvious to one skilled in the art at the time the idea was put forward” (Schmookler 1966) Innovation: making an idea for a new product or process real, putting it into practice; includes development and commercialization; usually done by a team or company (here comes the market). Diffusion: the spread of a new invention/innovation throughout society or at least throughout the relevant part of society (without diffusion there is no market). What produces innovation? OECD Frascati Manual definitions (statistical manual) Basic Research: experimental/theoretical work undertaken primarily to acquire new knowledge of the underlying foundations and phenomena and observable facts, without any particular application or use in view Applied Research: original investigation undertaken in order to acquire new knowledg , directed primarily towards a specific practical aim or objective Experimental Development: systematic work, drawing on existing knowledge gained from research and practical experience, directed to producing new materials, products and devices; to installing new processes, systems or services; to improving substantially those already produced or installed. Linear model of innovation Stylized view of innovation as outcome of a linear process from basic research through to commercialization Science base: set of knowledge that the society accumulated overtime Diffusion à make money Technical progress à technological advantage Example: pharmaceutical innovation (most science based industry we can think of) - Basic research done by the firm itself, universities, and government laboratories (because it’s far away from the market) - Applied research – directed at specific disease; screening compounds in test tubes; testing compounds on animals. - Development - series of clinical trials (Phase I, II, III) - New Drug Application (NDA) submitted to regulatory agency for marketing approval if Phase III successful and drug expected to be profitable - Commercialization – determine packaging and dosage information; scale up manufacturing; marketing drug to doctors and consumers. - Diffusion - use of drug spreads throughout the relevant doctor and patient population. May also include process of satisfying regulators and adapting drug delivery in other countries. Pharma innovation highly uncertain process; most compounds fail. Example: software innovation - Basic research - relies on mathematics and logic, sometimes quite old connection to current research in these areas is rather remote and their importance depends on the particular application. - Applied research - cryptography, sorting algorithms, data storage systems, and numerical methods more important for software development. - Invention - the concept of what a useful program would do and specification of its basic features. - Development - creating detailed specifications, coding, and alpha testing. - Commercialization - beta testing phase; marketing; successful sale. - Diffusion – persuading potential customers to adopt software feedback leading to modifications larger customer base finds problems that were not foreseen during development. A prolonged incremental process even after the first sales (better versions). Comparing the examples Commonalities: - Innovation in both industries rests on science, but different kinds - Innovation created in response to perceived consumer demand Differences: Science from technology Linear model does not always apply Innovation can lead to two broad types of scientific development: 1. Drive to understand why something works leads to new science 2. Deliberate attempts to improve a technology that requires further understanding of the science behind it. Improvements in technology can make the science behind it more economically valuable and hence easier to pay for. Example: Louis Pasteur (19C France) - Worked for a vintner (produttore di vino) trying to improve the fermentation process of beetroot wine - Traced the source of contamination to micro-organisms that could be eliminated by heating liquids to temperatures between 60 and 100 degrees Celsius. - His work yielded both scientific and technological advances: Contributed to germ theory of disease (basic science) Pasteurization (a commercial innovation) à best application on milk Feedback from applied research, innovation, and development to the science base. Key idea: technological knowledge often precedes scientific knowledge and that this leads to scientific developments that in turn improve technology (other examples). Pasteur’s quadrant: Applied and Basic Research Instrumentation for science Availability of tools: better instrumentation (technology) can lead to progress in science One scientific or technological area can influence development of a completely different area via the provision of improved instrumentation. Examples: - Success of Pasteur’s use of microscope to observe fermentation and develop germ theory led to increased demand for microscopy improvements, which in turn aided scientific investigation. - Development of huge superconducting magnets for the various particle accelerators such as the supercollider at CERN has led to improvements in materials science. - Development of laser technology led to its use in greatly speeding up DNA sequencing beginning in the 1980s, facilitating scientific research in the biogenetic area. Learning by doing Learning process (another important ingredient) Describes the process by which experience with a new technology leads to knowledge and productivity growth in it use (the more you train the better you get) Accumulation of knowledge generated by production feeds into future productivity growth via enhanced capital goods (affect the quality). Learning curve: empirical regularity that a production process becomes more efficient as it is repeated, but at a diminishing rate. Reasons why costs of production fall as experience is gained: - Accumulation of experience by workers. - Learning by management that leads to better organization of productive tasks, better timing in the ordering of parts, etc. - Improvements in design or materials over time. Models of the learning curve relate cost of producing the next unit of a complex product to number of such products already produced. Simplest model: Elasticity b measures the per cent reduction in unit cost from a per cent increase in output: Implication of constant elasticity (b doesn’t change overtime): magnitude of cost benefit from increased output declines as output grows. Learning curve for laser diode made by Sony: - log (price) = log (5038)- 0.373 log (shipments) - The coefficient 0.373 implies that every time the past number of shipments doubles, unit cost falls 37%. Learning by using Products are often improved, developed and enhanced based on experience of the product in use. - Learning that takes place as a result of experience with using a new innovative product. Technological change and innovation do not end when the technology is diffused to users. - Technologies continue to improve due to feedback from use and users. Feature of complex capital goods, whose performance is not fully understood until they are used. Learning by using also can contribute to product differentiation. Learning by using example Evolution of Boeing aircraft (747) Many improvements made to planes after their first use: - embodied - physical change to the good - disembodied - changes to its maintenance or use Main improvement - longer and larger versions of the same model of aircraft as experience is gained in their use. Also numerous other changes made in the form of engines, configurations, design for freight or particular customers. Ikea Hacks Uncertainty and timing Striking feature of innovation: inability of inventors to forecast the ultimate implications and uses of their inventions. Some examples: - Computers - forecast by Thomas Watson (CEO of IBM) in 1943 that the worldwide demand was likely to be only 5. - Radio - Marconi envisioned narrowcasting (ship-to-ship communication) as the main use, not the broadcasting that is a major use today. - Internet - ARPANET created for the U.S. Defense Department using distributed communication protocols as a defense against losing communication ability if a single node goes down. Multiple such networks linked during the 1970s to create a primitive internet. Commercial use did not really take off until Tim Berners-Lee at CERN combined the internet node system with hypertext to create the world wide web in 1989. Two features of major inventions and their impact: - Length of time between invention and when its larger economic impact becomes apparent - Need for complementary inventions to enable the first invention have wider use: E.g., semiconductors in the case of computing and hypertext and personal computers in the case of the internet. Implications for risk: - Ordinary risk associated with the process of research and invention - Uncertainty over true benefit of invention - very difficult to assess when it is undertaken. Sources of uncertainty: - Technical risk: uncertainty over whether something will work and how it will work - Market risk: uncertainty over market demand General Purpose Technologies General Purpose Technologies (GPTs): technology with (potentially) many different applications To make them useful, GPTs usually require the reorganization of production; possibly also the broader economy (this tends to slows down the diffusion) Examples: steam engine, electricity, semiconductor, internet, artificial intelligence (AI) Often requires standards of interoperability for technology to spread across firms, sectors, and regions. Direction of innovation What kinds of innovation are produced? What determines the direction of innovative activity? Innovations produced depend on: - Ease of supply (technological opportunity) i.e. availability of science and technology needed - Size of perceived demand - Availability of intellectual property protection - Public procurement Types of innovation: 1. radical vs incremental Incremental innovation: improvements in existing product/process that enhance performance or attractiveness to customers. E.g., the latest iPhone Radical innovation: create entire new markets. E.g., the automobile; smartphones 2. Process and product innovation Product innovation: creation of a new good or service for sale (increases the firm's demand; effectiveness depends on the market structure, price) Process innovation: new way of doing something (typically cost reducing). Very often this process of innovations go together They often go together within a firm: The relative importance of process innovation varies across technologies. 3. User innovation Users themselves may innovate, modifying a product to suit their needs. Examples: - Sporting equipment, e.g. windsurfing, skateboarding, snowboarding equipment - Open source software (OSS) Importance of “lead users” - those on the frontier in the use of the product, who discover needs that later users may also experience. User innovation widespread in industry with firm customers suggesting modifications to the capital goods they purchase Innovation as a quasi-public good Optimal allocation of resources to invention requires: - Utility and production functions are well-defined functions of commodities. - No uncertainty (now, or in the future, in production or consumer taste). Fails: innovation is highly risky - Inputs and outputs are private property. Fails: innovative idea does not act like private property - No indivisibility in production or consumption. Fails: innovation is discrete, once made, can be used an arbitrarily large number of times. → Perfectly competitive markets are unlikely to allocate enough resources to invention and innovation because of uncertainty, inappropriability, and indivisibility. Suggests need for innovation policies Summary Innovation: technological innovation that improves the welfare of society Basic model: innovative process linear, from scientific base to commercialization of new products and processes Along linear path, many feedback loops Uncertainty and risk inherent in innovation Knowledge created by innovative activity has quasi-public good characteristics, important implications for firm strategy and public policy 18/09/2024 SUPPLY AND DEMAND FOR INNOVATION (Lecture 3) Overview Intro – examples Supply factors: - Technological opportunity - Appropriability - Absorptive capacity - Financing Demand factors - Market size - Consumer taste and willingness-to-pay - Regulatory mandates - War Direction of innovation Simultaneous innovation Introduction Two examples of important innovation with very different origins and timelines: - Covid vaccines - Human flight The aim is to understand why those innovation took such different timelines Introduction – covid vaccines in the US In May 2020, U.S. government: Operation Warp Speed (OWS) - Goal: accelerate the development, manufacturing, and distribution of COVID-19 vaccines, therapeutics, and diagnostic tests. - OWS was a public-private partnership between various government departments and private firms. OWS strategies: - Simultaneous FDA review of clinical trials for multiple vaccines; - Manufacturing candidate vaccines while pre-approved; - Use of Department of Defense to coordinate supply, production, and deployment. Results: - 8 companies funded in August 2020 to pursue vaccine candidates - 3 companies produced successful vaccines by the end of 2020 (Johnson and Johnson, Astra-Zeneca, and Moderna). - 4th project, Pfizer-BioNTech, not funded by OWS but benefited from an advance purchase agreement with the U.S. government (and received 375 million euro funding from German government) Illustrates the Importance of a clearly identified need sending a strong demand signal that innovation would have a market as well as the role of a focused government effort. This innovation was developed thanks to a strong demand signal Introduction – covid vaccines in the EU Typical stages of a vaccine development What happened with covid is that all these phases where fastest than normal (example of how the role of the government can accelerate innovation) Introduction – human flight Quest for human flight goes back to ancient Greece and kite flying in China (extensive design and drawings by Leonardo da Vinci during the 15th century). 1783 - first really successful flight by Montgolfier brothers, using hot air balloon. 1903-1908 - modern human flight begins with Wright brothers and Alberto Santos-Dumont. Why was human flight achieved in the early 1900s and not earlier? The driving forces appear to have been - desire to be first, - the supply of the basic components, - understanding of the mechanics from previous failures, - and the potential for profit. Determinants of invention and innovation Innovative outcomes determined by: 1. Supply of the inputs. 2. Demand for innovative output. Our examples: - Driving force behind Covid vaccines was immediate and pressing demand. - Driving force behind heavier-than-air flight was long-felt human desire for flight together with supply of relevant inputs to the innovation. Demand was not enough, without supply Supply of innovation The most important supply factor for innovation: availability of innovators, which depends on capabilities and incentives: Capabilities/ability of individuals: - Nutrition - Income level - Education and level of science and technology Incentives for innovation: - Ability to finance and secure returns to innovation - Life expectancy - Willingness to bear risks - Religion - Values Technological opportunity An important supply factor – the science and technology knowledge to which inventors have access. Technological opportunity refers to the availability of the relevant knowledge for making inventions in a particular area - Rapid covid vaccine development depended in part on science learned as a result of earlier SARS viruses - Human flight had to wait until the science and technology of materials and engines was sufficiently developed. Not all individuals and firms have easy access to the relevant S&T (science and technology): - Lack appropriate education (“missing Einsteins”) - Lack absorptive capacity Missing Einsteins and Marie Curies? Invention, innovation, and entrepreneurship unequally distributed across the population with respect to gender, race, and family background. - Suggests “missing” inventors Exposure to innovative activity during childhood is a critical factor in determining whether an adult becomes an inventor (Bell et al. 2019) - Gender-linked - female invention linked to childhood exposure to female invention; not to male invention. - Parental background (STEM education and inventorship) predict entry into inventing - effects much larger for males than females (Hoisl et al. 2021). Absorptive Capacity Absorptive capacity: ability to recognize the value of new information (broadly speaking), assimilate it, and apply it to commercial ends (Cohen and Levinthal 1989) - Model of R&D competition in an industry with n number of symmetric firms, equilibrium R&D investment as a function of level of spillovers from competitors' R&D and absorptive capacity of the firm. Assume static model with two firms i and j, solve for Nash equilibrium in R&D investment where each firm’s profits Π depends positively on its own stock of knowledge K and negatively on its rival’s stock of knowledge (my profits are a function of two elements): A firm’s stock of knowledge is a function of its own R&D (R), spillovers from its rival’s R&D, and general knowledge level of economy T: measures the spillovers (ripping the benefits of others’ investments) of rival’s R&D (things that I can use, discovered by others). 𝛾 is an increasing function of the firm’s R&D and parameter 𝛽 > 0 that indexes the ease of learning for a given level of R&D. 𝛽 is assumed to increase the marginal effect of R&D on absorptive capacity but to reduce the level of absorptive capacity I can affect my absorptive capacity investing more in R&D (you increase tour absorptive capacity and you can benefit more from the spillover) Return to a firm’s R&D is given by the derivative of profit with respect to R&D: First term: positive impact of firm’s knowledge stock on its profits, which includes a spillover term mediated by the impact of firm’s own R&D on its absorptive capacity. Second term: negative because rivalry effects imply a negative impact of the other firm’s knowledge stock on profits, one that is larger in absolute value if either spillovers or absorptive capacity are larger. Equilibrium: set the return 𝜌𝜌 equal to the cost of R&D, which is assumed to be one. Solve for Rs (too complex for analytical solution). Cohen and Levinthal show that 1. If complexity 𝛽 increases, the return to R&D and the level of R&D will increase because own R&D matters more for absorptive capacity and competitors are less able to exploit spillovers. 2. Given the presence of absorptive capacity, the impact of spillovers on R&D and its return is ambiguous. They increase the profitability of own R&D but there is a negative effect from their impact on rival’s R&D. 3. As in the case of spillovers, another incentive to invest to increase absorptive capacity comes from the presence of technological opportunity T (external knowledge from universities, firms outside sector, etc.). Decreases in ease of learning → increases in R&D investment by the firm If firms can affect absorptive capacity via investment in R&D, increases in spillovers can → increased incentives for R&D. - Contrary to the earlier work which assumed implicitly that spillovers reduce R&D incentives by making imitation lower cost than invention. Implication: firms may invest in basic research in order to increase their absorptive capacity, in spite of the fact that such research also has broader spillovers. Broader implications: countries may also vary in their ability to absorb and use frontier science and technology; this fact is highly relevant for the failure or success of development strategies Financing innovation Key element of innovation cost: cost of financing the resources needed to develop an invention and bring it to market. Financing innovation challenging because cost of external finance higher than required return: - Asymmetric information for investors - Moral hazard in financing - Lack of securable assets Result: - some projects not being undertaken; - some individuals may have better access to funds than others, another potential source of missing Einsteins. Overall, the main sources of finance for innovative startups are self and bank loans: Demand for innovation Where does demand for innovation come from? 3 types of actors: Consumers: - Consumer demand less important for radical innovations - Focus on incremental innovations to familiar technologies Firms: - Demand depends on expected profit from investments and innovation choices - Signals from customers/consumers Governments (via public procurement): - Policy goals (e.g. environmental mandates leading to new technologies) - Defense/geo-political considerations War and demand for innovation War is the impetus behind many important innovations - E.g., boring machine (those used to excavate tunnels) for cannon used in steam engine development Importance of science and technology during World War II: - atom bomb, radar, microwaves, and medical treatment improvements in blood transfusion, skin grafts, and trauma (Gross and Sampat 2023) - also led to creation of national science policy and National Science Foundation (NSF), and U.S. Atomic Energy Commission (AEC) - Pioneering of IA (Turing…) Even more recent – improvements in drone technology Direction of innovation Direction of innovation: (infinitely) many paths in different directions that might be pursued at a given point in time. Limited resources to invest, need to choose path - Choice determined by same factors that determine the overall level of innovation: the science base, expected innovation cost, expected profit from the innovation, risk and uncertainty, etc. Innovation studies classify paths in different ways: - By broad science/technology field - Process-oriented vs. product-oriented - Incremental vs. radical Influence of supply: - Current state of scientific or technological knowledge (tech opportunity) - Composition of potential innovators Influence of demand: - Technological bottleneck or imperative need for improvement - Relative factor prices/interruption of supply Simultaneous invention Invention often nearly simultaneous Two or more individuals that may or may not be in contact with each other come up with the same or very similar ideas at almost the same time Examples: - Calculus (Newton, 1671 and Leibniz, 1676) - Theory of natural selection (Darwin and Wallace, 1858) - Principle of least squares (Legendre, 1806 and Gauss, 1809) - Telephone (Bell and Gray, 1876) - Flying machines (Wright, 1895-1901, Langley, 1893-1897) - Photography (Daguerre-Niepe and Talbot, 1839) - Telegraph (Henry, 1831, Morse, 1837, Cooke-Wheatstone, 1837, and Steinheil, 1837) Why is simultaneous invention common? Supply and demand factors often apply to economy or society rather than to individuals. Therefore it is - Likely that more than one individual will perceive the opportunity to make a scientific discovery. - Likely that more than one individual will perceive the opportunity to make a technological invention that satisfies consumer needs and where the cost of the invention is recoverable via potential profit. Now it’s less common because we communicate more Summary Level and direction of innovation determined by interaction of supply with demand Non-economic factors and chance also matter, but are less subject to policy targeting or conscious strategy by individuals and firms. Supply factors: - Current science and technology base - Individuals and institutions with the relevant knowledge - Availability of finance - Cultural attitudes (toward risk, newness, and societal values) Demand factors: - Consumer needs and willingness to pay - Market size - Shocks to relative input costs - Regulatory mandates - Perceived benefit of potential innovation Many inventions and scientific discoveries are made simultaneously by two or more individuals. 23/09/2024 APPROPRIATION MECHANISMS (Lecture 4) Overview Basics of intellectual property (IP) rights (the incentive to do innovation is money) Main features and laws associated with each type if IP right - patents including utility models, design rights, and plant patents - copyright - geographical indications - trademarks - sui generis IP rights - trade secrecy Comparing and combining the different IP rights Introduction We need IP because “Innovation” is a quasi-public good - It is non-rival, meaning one person’s use doesn’t reduce availability for others. - It is partially excludable, with mechanisms like patents, but these are limited in time or scope. - It generates positive externalities, benefiting society (es. spillover) beyond the innovator. - It faces underinvestment without public support due to difficulty in fully capturing its value. Incentives for innovation depend on methods by which innovators (expected) secure returns to their innovative efforts Appropriation methods to secure returns: Informal: based on actions undertaken by innovator without recourse to legal protection. EXAMPLES? Secrecy Formal: defined by the legal system, often requiring some kind of registration. EXAMPLES? Intellectual property Focus on formal appropriation mechanism: intellectual property Also discuss informal appropriation mechanism in form of secrecy The term “intellectual property” is commonly understood to refer to the intangible products of human creativity such as: - Knowledge of how to make or do something - Creative works such as books, movies, musical recordings, photographs, etc. - New designs for commercial use - Original product markings and trade names - New plant varieties Often non-rival and non-excludable Not really property in traditional sense Legal protection necessary to exclude others from use Patents Copyright Trademarks Design rights Plant patents Geographical designations [Trade secrets] Intellectual property addresses problem created by non-excludability Other arguments for the creation of intellectual property: - Moral rights to the creator in the case of artistic creations, granting the creator the right to control their work. - Consumer protection from confusion and potential fraud Coverage of intellectual property right generally restricted to the country or region that grants them - some international cooperation Patent A patent confers the right to exclude others during a limited period from the use of an invention in a given jurisdiction. Grants broad legal protection because protects against any use of the patented invention Patent can be sold (uncertainty about the market value), licensed, or used as a security But uncertainty associated with validity and scope of patent Patents granted only to patent eligible inventions - any product or process invention in any field of technology, with some exception No obligation to use patented invention Patents are national rights - several regional patent systems, e.g. European Unitary Patent (Ufficio Italiano Brevetti e Marchi) Requirements to obtain patent protection largely harmonized internationally (following TRIPS): 1. Novelty: new to the world 2. Non-obviousness: not an obvious extension of existing invention 3. Useful: can be used in practice - Patent term 20 years from the date of filing the patent application - Patents published 18 months after filing, disclose technical information in a standardized format (they do lot of research à after 18 months they publish it if it has the requisites) Economic justification for patent system: 1. Invention motivation: the right to exclude others from using the invention creates an incentive to invent. 2. Invention dissemination: patents disclose an invention and therefore facilitate knowledge diffusion. 3. Induce commercialization: patents also provide incentives to develop and commercialize an invention by excluding others from this activity for a time. 4. Exploration control (prospect theory): ownership of a broad patent on an initial breakthrough allows for exploration and development or in a number of directions without the wasteful effort that would occur if anyone could enter the area. 5. Market for technology: patents enable a more efficient market for technology and its development. In practice, patents often used by firms as part of a complex strategy to secure returns to their innovations. Utility models Some countries grant utility models - Also known as petty patents or utility patents - Weaker form of patent with less stringent patentability requirements - Utility models generally cheaper to obtain and maintain (patents are quite expensive) - Shorter grant lag - Shorter protection (generally 6 to 15 years) - Lower patentability requirements - In some countries, no substantive examination required Useful for protecting inventions that make small improvements to, and adaptations of existing products or that have a short commercial life. Often used by local inventors in developing countries Plant patents Protection for new plant varieties relatively recent (in U.S. in 1930) Effort to increase incentives for innovation in agriculture sector Allows for protection of new varieties created via cuttings and roots rather than seeds. In 1961, International Union for the Protection of New Varieties of Plants (UPOV) created UPOV Convention created sui generis plant breeder's rights for a new plant variety: - New plant must be novel, which means that it must not have been previously marketed in the country where rights are applied for. - New plant must be distinct from other available varieties. - Plants must display homogeneity. - Trait or traits unique to the new variety must be stable so that the plant remains true to type after repeated cycles of propagation. In U.S., 3 types of intellectual property protection available for plants: 1. Plant variety protection (PVP) – seeds, tubers, and asexually reproduced plants (issued by the Plant Variety Protection Office of the Department of Agriculture). Term is 20 years (25 for trees and vines). This IP right is subject to a research exemption for the purpose of breeding new varieties as well as a farmer’s exception to allow for the saving of seed to replant. The novelty requirement is much weaker than that for plant patents or utility patents. 2. Plant patents – asexually reproduced plants (issued by the US Patent and Trademark Office). Term is 20 years from filing date. Unlike the case of utility patents, enforcement of a plant patent requires proof that the copy is the progeny of the patented plant. 3. Utility (invention) patents – for genes, traits, methods, plant parts, or varieties (issued by the USPTO). Term is 20 years from filing date. In Europe, the main forms of protection are plant variety rights (PVRs), patents, and trade secrets. Plant Variety Rights (PVRs) – Community Plant Variety Rights (CPVR) - What It Covers: Plant Variety Rights (PVRs) protect new, distinct, uniform, and stable plant varieties. This protection applies to varieties of plants that can be consistently propagated and reproduced. - Legal Framework: In Europe, plant breeders can obtain Community Plant Variety Rights (CPVR) under the Community Plant Variety Office (CPVO) system, which grants exclusive rights to commercially exploit a new plant variety for up to 25-30 years, depending on the species. - Requirements: The plant variety must be: New (not previously commercialized), distinct (clearly distinguishable from existing varieties), uniform (consistent in key characteristics across different plants) and stable (unchanged after repeated propagation). - Protection Scope: The holder of a CPVR can prevent others from producing, selling, or using the protected variety without their permission. - Exemptions: Some exemptions exist, such as the farmer's privilege, which allows farmers to save seeds from certain crops for their own use without infringing on the breeder's rights. Design rights Design rights (patents) protect ornamental aspect of an article. Design dictated by function or purpose of a product not protected. Cover shape, pattern, color, etc. of an article. Grant owner of registered industrial design or design patent the right to prevent third parties from making, selling or importing articles bearing or embodying a design which is a copy, or substantially a copy, of the protected design In some countries, no examination/registration required Shorter protection term Scope not based on verbal description but solely on graphical depiction of design Geographical indications (GI) Geographical indication (GI) is a designation that a particular product is produced in a specific region, excluding similar products produced elsewhere from claiming they come from the region (es. DOP, DOC, …) - Examples: Champagne, Roquefort, Parmigiano Reggiano GIs identify the source of a product associated with certain characteristics GIs similar to trademarks, but more restrictive as they must be connected to a specific place. How about Italian sounding? Marketing or branding strategy where products, especially food and beverages, are given Italian-sounding names, packaging, or imagery to evoke an association with Italy, despite not being authentically Italian Es. Parmesan, Prosciutto à there in no problem of property right, the name is written in a way to sound like an Italian product but it’s not an Italian product for real (it’s not patent/GI infringement) Copyright Copyright covers original works of authorship that are fixed in tangible form, such as books, artworks, prints, photographs, films, recordings, but also software. Copyright grants creator exclusive control over their creation: the rights to reproduce the work, produce derivative work including audiovisual adaptation, to perform or record the work, or to display the work. Copyright only protects the literal expression of an idea, not the idea itself. Limitations and exceptions (e.g. fair use) Registration generally not required but possible Copyright term life of the creator plus 70 years Trademark Trademark: “any word, name, symbol, or device, or any combination thereof [...] used by a person...] to identify and distinguish his or her goods [...] from those manufactured or sold by others and to indicate the source of the goods”. Purpose: distinguish one product from another and to identify the source of the product (producer). A trademark is a right to exclude other from using the mark or one that is substantially similar, unless it is licensed to them by the owner of the trademark. Requirement: trademark has to be distinctive. Protection available in form of registered and unregistered trademarks. Trademark term 10 years, renewable indefinitely Informal protection 1. Trade secrets 2. First-Mover Advantage 3. Complexity and Tacit Knowledge 4. Lead Time and Continuous Improvement 5. Brand Loyalty and Reputation 6. Network Effects 7. Strategic Partnerships and Exclusive Contracts 8. Control Over Distribution Channels 9. Customer Lock-In 10. Product Bundling and Ecosystem Building 1. Trade secret Trade secret: information kept within the firm, where firm has made an effort not to reveal it to public, and where information is not already generally known. Not registered, has indefinite term, only offers protection from misappropriation. Imitation without misappropriation is allowed. Trade secrets include customer lists, formulas, pharmaceutical test data, methods of production, advertising strategies and marketing plans, etc. Legal provisions granting trade secret protection vary considerably across jurisdictions. Es. Recipe of Coca-Cola 2. First-Mover Advantage Being the first to bring a product or service to the market can provide a competitive edge that others struggle to overcome (Amazon). By quickly capturing market share, building brand recognition, and establishing customer loyalty, innovators can make it harder for competitors to displace them, even if similar products or services arise. 3. Complexity and Tacit Knowledge Innovators can make their technology or processes so complex or dependent on specialized, tacit knowledge that it becomes difficult for others to replicate (Tesla, SpaceX). Innovators can use unique methods, machinery, or expertise that aren’t easily transferable, often requiring years of development to master. 4. Lead Time and Continuous Improvement Innovators can focus on maintaining a fast innovation cycle, constantly improving their products and processes so that by the time competitors catch up, they are already onto the next version (Apple & Iphones). By maintaining a rapid pace of innovation, the company ensures that even if competitors copy their products, they are still behind. 5. Brand Loyalty and Reputation Innovators can build a strong brand reputation that becomes closely associated with their innovation, making it difficult for competitors to compete, even with similar products (Dyson). Strong customer loyalty, positive reviews, and a premium brand image can create a competitive moat that protects an innovator's market position. 6. Network Effects Innovators can create systems where the value of their innovation increases as more people use it, making it difficult for competitors to attract users away (Facebook). Once a large network is established, it becomes less attractive for users to switch to a competitor, thus protecting the innovator's position. 7. Strategic Partnerships and Exclusive Contracts Innovators can form exclusive relationships or partnerships with key suppliers, customers, or distributors to block competitors from gaining access to critical resources or markets (Apple has secured exclusive deals with manufacturers like Foxconn and TSMC to ensure the supply of key components for its devices, making it harder for competitors to access the same resources). These strategic alliances create a barrier to entry for other firms, protecting the innovator's competitive position. 8. Control Over Distribution Channels Innovators can establish control over distribution channels, ensuring that their products are available in key markets while competitors are limited in access (Zara). Vertical integration of distribution allows firms to control both production and market access, limiting competitors’ ability to match their speed or presence. 9. Customer Lock-In Innovators can design their products in a way that makes it difficult or costly for customers to switch to a competitor’s offering, creating customer dependency (Microsoft Office). Innovators use platform dependency, proprietary tools, or ecosystem-based services to lock customers in, thereby creating a natural barrier to competition. 10. Product Bundling and Ecosystem Building Innovators can bundle their product with other complementary products, making it more attractive than standalone competitive offerings (Apple devices and services). By offering a suite of products and services that work together, innovators can make it inconvenient for customers to leave the ecosystem for individual competitors' offerings. IP use by the top 2000 R&D performers 2010- 2012 Many more firms make use of trademarks than patents. About half of patenting firms also use trademarks. Effectiveness of appropriability mechanisms for product innovations Informal mechanisms for securing returns to product innovations (lead time, sales and service) generally more important than formal methods: For process innovations, secrecy is now the most important mechanism for securing returns: Summary Creators of ideas and intangible products motivated by ability to capture some returns from their innovative activities. Intellectual property: - Ensures development of future prospects from an invention; - Provides disclosure of technical information that might otherwise be kept secret; - Enables trade in technology; - Ensures “moral rights” for creators even if they make no effort to claim ownership; - Provides protection via geographical indications to those whose traditional inventions do not rise to patentability or other intellectual property protection due to their historical development. Intellectual protection comes at a cost which creates trade-off in designing and using intellectual property system. 25/09/2024 INNOVATION AND COMPETITION IN FIRMS (Lecture5) Overview Basic landscape of R&D and innovative activity across industries (sectors) and firm sizes Modeling the relationship between market structure and innovation Empirical evidence on market structure and innovation Innovation and the evolution of industries and their structure (how they co-evolve) Introduction Interaction between innovative firms (established and startup) in the market. Innovation has potential to change market structure As result of innovation, industries develop, evolve, and even disappear What market structure is most conducive to innovation? Has innovation an effect on market structure? What type of firm innovates under which circumstances? Important policy implications R&D funding in the U.S. Overtime there was a sort of switch of the Federal funding (was the most important part of the R&D spending) and the private ones (overtime they became the most important part of the R&D spending) Showing the growth of business funded R&D in the US during the past six decades, and the corresponding fall in R&D funded by the federal government. As a share of GDP, total R&D today is at roughly the same level as in 1962. Business-financed R&D share of total R&D Growth in business R&D also visible in the other major R&D-doing countries The US is being growing until 1999, it fell a bit later Increasing pattern overtime (pretty much for all the countries) Introduction Industry R&D spending has increased during the past 50 years Main reasons: - Increases in technological opportunity/complexity - Increases in market demand for new products (also increases in market size due to globalization) But increase (unfortunately) has not led to as much increased productivity and economic growth. This is called “Red Queen Effect”: running faster to stay in place Stylized facts We use “Stylized facts” when we find some empirical regularity that is true for more country and is during overtime R&D investment varies (very heterogenous) considerably across industries Industry (regardless of firm size) is the most important predictor of investment in R&D Majority of R&D is performed by large firms with >1,000 employees When small and medium sized firms perform R&D, their intensity (es. R&D to Sales) is much higher. R&D concentration – World today R&D scoreboard from EU commission Firms globally rent according to how much di they spend in R&D What we can see? Big player US; Emerging player China Main industries à Software and Pharmaceutical Germany is the only European country, but the industry in this case is Automobiles R&D concentration – World, as it was in 2018 !"#$%& 0123"( 067&89:; a – bt Because a-bt is a monotone decreasing function of t, we can write the share of adopters at time t* as Φ( ∗ ), where Φ(·) denotes the cumulative normal distribution function, - t* is equal to (a - B*)/b. Normally distributed benefits and declining costs imply an s-curve that has the shape of the cumulative normal distribution. Epidemic model No heterogeneous consumer tastes or willingness to pay. Assumes adoption spreads throughout the population as consumers encounter those who have already adopted and learn of the advantages of the new technology. Initiated by small number of consumers who adopt early and then encounter the remainder randomly. All (or a share) of those contacted adopt. Eventually enough people have adopted so that few of those contacted randomly have not already adopted, and the process ends. Illustration of some scurves for adoption with various means and standard deviations of the adoption time. Note that for the logistic or for any symmetric distribution, the mean and median coincide, so at the mean, half the population has adopted. Adoption as investment under uncertainty Decision to adopt involves uncertainty Potential adopter compares upfront cost with an uncertain stream of future benefits. Upfront costs are sunk, and decision cannot be reversed without additional cost. Decision not “adopt or do not adopt” but instead “adopt now or wait to decide whether to adopt later.” Model adoption decision as real options model (similar to Dixit and Pindyck (1994) for investment under uncertainty). A financial option is a contract which grants its owner the right, to buy or sell an underlying asset at a specified strike price on or before a specified date. There is no requirement that the owner exercise this right. Real options are those where the asset is real (tangible investment). In adoption setting, no contract, only option to adopt a new technology at any point in time at an uncertain price and whose payoff is uncertain. Real options are often evaluated using a decision tree with two choices at every branch (adopt or not) and a value of each branch computed by looking forward down the tree. Factors affecting diffusion Ideas? Diffusion of innovation has same broad determinants as innovation itself: - Demand for the new technology - Cost of adopting new technology - Level of uncertainty, availability of information (not only on how well technology works but also its use/applications) - Network externalities - Market structure - Cultural and social determinants - Regulatory and institutional environment - Competition from old technologies Invention during diffusion process in the form of tweaking and adaptation Benefits of adoption of a new technology depend on: - Perceived improvements it offers (otherwise there is no point in adopt it) in consumption or industrial use. - Closeness of potential substitute technologies, either new or those in prior use. - Extent to which new technology supported by a network (about which more in a moment). - Availability of complementary goods (e.g. tools, worker skills), maintenance services. Costs of adoption of a new technology depend on: - Price of new technology - Cost of financing the necessary investment - Switching costs (es. Learning cost) from the previous technology - Because technology adoption largely fixed cost, scale of potential use affects adoption General purpose technologies and standards Technology that takes a whole bunch of new innovations (pervasive) Es. Use of electricity in homes needed even further investments: - Construction of a network to deliver the electricity - Education of the consumer, given the apparent new danger of electrocution when misused. (those things slow down the adoption) Trends in electrical and computing patenting 1840-2014 Illustrates the similarity of technology development in electrical and computing technology over time. Both are GPTs that take a long time to fully develop and be widely adopted. Slow diffusion and productivity slowdown - Slow diffusion of new general purpose technologies results in slow rate of productivity growth (impact on productivity) - Some changes not reflected in conventional productivity statistics (very often the initial diffusion of GPT is very slow) What about today? Two sets of technologies have the potential for substantial impact if they can be fully and safely diffused: 1) various types of clean technologies such as electric vehicles, and 2) artificial intelligence applications. 1. NEED: investment in infrastructure, realignment of the end-user delivery. Coordination. Stranded assets (investment that someone realised in the past that became obsolete with a new technology; es. gas pipes in the case of EV). Clean technology development and diffusion face a double externality problem in that there are the usual positive externalities from R&D in this area as well as positive externalities from their diffusion in the form of less pollution and global warming. - This suggests an even greater role for government policy towards increasing adoption 2. Despite obvious benefits AI faces great headwinds. Privacy & liability (think of the self-driving car, if there is an incident who will pay for that: there is something missing); you need to educate people to the use of AI; risk of segregation and discrimination (ethical concern) Network goods and standards Network goods: technology whose value to one user depends on use by others. Generate network externalities that lead to increasing returns Often require standards (you need the dominant design to emerge and be the leader of the market) and coordination Two types: - Direct networks: Communications networks such as telephone, fax, email, messaging systems - the value to a user depends on with whom they can communicate. (it is a matter of the number of consumer in the same network) - Indirect networks: Virtual networks created by “hardware/software” systems - the value depends on the number of other users because the existence of more users means more software available due to economies of scale in providing such “software’”. (is a matter of number of application, ecc… available in the network) Network externalities and diffusion Better technology may not win network competition (may not became the dominant design/standard es. Keyboard à today standard was not the best one) Small historical accidents at the outset can tip adopters to choose a standard that later users perceive as non-optimal (examples: QWERTY keyboard, VHS vs Betamax, DVD vs Blu-ray). (this kind of accident is called:) Path dependence: the dependence of economic outcomes on the path of previous outcomes, rather than simply on current conditions, leading to situations where “history matters.” Lock-in phenomenon: form of economic path dependence whereby the market selects a technological standard and because of network effects the market gets stuck with that standard even though market participants may have been better off with an alternative. Summary Diffusion is the way the benefits of new technology reach society. Diffusion can be slow due to a number of factors: 1. Uncertainty over the benefits and costs; 2. Need for complementary investments by the adopter; 3. Need for standards to make it useful if there are network effects Empirical work studying the factors affecting diffusion has confirmed that profitability and other financial factors, firm concentration and size, complexity, customer relationships, worker skill and education, uncertainty, and the network nature of the technology all affect its diffusion. Technological standards are specifications of functions and the way they must be performed, or of the input/output parameters. Network goods are goods whose value to one user depends on use by others. Network externalities are the benefit or cost conferred on others when an individual chooses to purchase a network good. 07/10/2024 INNOVATION STRATEGY (Lecture 8) Overview How firms create (define) and capture value from innovation (rip benefits out of the innovation) Strategic goals for value creation and appropriation Characteristics of different research strategies - Open innovation - Make or buy? …or collaborate? Network effects and innovation strategy Strategies for network competition Introduction Innovation strategies help to create value for the firm (first you develop the innovation then you need strategies to create value for the firm) What is the “best” innovation strategy for firms and individuals? How should an innovative firm structure its R&D efforts? Broadly speaking, differences between established firms and start-ups imply different types of innovation: - Established firms: incremental (builds closely on prior technology) - Start-ups: radical, new young firm that enter the market to bring its innovation (highly innovative, typically really small) (entirely new combinations of knowledge) Increased importance of platform technologies creates new challenges for innovation strategy Value creation and strategic goals Objective of innovative activity: value creation (value for the firm à profit; value for the consumer à utility) Describes act of innovating a product/service that provides benefits to customers large enough that they are willing to pay more for the innovative good than it costs to make (including the R&D and/or the innovation effort) Different ways to approach innovation: incumbents vs startups Value creation and strategic goals: established firms They are already in the market and already produce something; when it comes to innovation incumbents have to face threats and opportunities Innovation determined by threats and opportunities in firm’s environment: - Threats: new entrants (like startups), existing competitor, technological paradigm shift (es. A firm that is producing a new machinery for packaging and then some regulation comes saying you cannot produce that kind of packaging so your force to rethink your product is completely useless) - Opportunities: technological trajectory Incumbents have sources of sustainable competitive advantage (sources of rent) help determine direction of innovation: - Brand recognition, distribution network, customer list, loyalty programs - Example: Amazon’s successful innovation in delivery of books, suggested expansion into delivery of other products using their existing shipping system Most of the time the innovation of established firms is incremental Incremental innovation reinforces existing core competencies Value creation and strategic goals: start-ups Main asset: idea Usually in search for competitive advantage (they don’t have it yet) Goal to create new industry, new niche in existing industry, or replace existing firms with better technology. Startups are more likely to succeed if - innovation radical (or disruptive) - upsets existing business models - architectural innovation - “reconfiguration of an existing system to link components in a new way” - that can make an entire system obsolete Value creation and strategic goals: Lessons from industry evolution Transformation of a generic need for innovation to a specific paradigm (how a generic need is transformed in an innovation) It is needed lots of experimentation (mainly by start-ups) following radical innovation, ultimately dominant design or paradigm emerges and incremental innovation takes off because technological trajectory has become clearer. NASDAQ and the development of the internet The NASDAQ index has a high concentration of companies in the technology sector, especially newer firms, so it is often viewed as a barometer of sentiment in this sector The market value of techy firms has been increasing overtime Illustrates the value creation associated with the diffusion of the internet and the development of complementary innovations (make the firm even more valuable). Note that the 2000 dotcom boom is just a blip on this graph (the right circle is the dotcom bauble) Value capture How do firms capture this value? Value created by innovation needs to be captured as profits Value capture: ability of firm to obtain some of the benefits of innovation via pricing above cost (not only the cost of production but also the cost of developing innovation and sometimes also recovery the cost of failed innovations). Also referred to as appropriability Value capture through formal and informal appropriation methods - Formal: intellectual property - Informal: secrecy, first-mover advantage, better sales and service etc. Value capture: complementary assets In areas with weak appropriability, possession of specialized assets necessary for exploiting innovation enables subsequent entrants to capture value of innovation (Teece, 1986). Innovation doesn’t come alone à Complementary assets: assets whose value when combined with an innovation is greater than their stand-alone value (make the innovation more valuable) Example: for social media firms, database of user information useful in adding value via advertising (also hard for entrants to replicate) Most innovations require other investments to be commercialized: manufacturing, marketing and distribution, after-sales service etc. (they are sometimes overlooked) Types of complementary assets: - Generic: generic assets, easy to resell in a secondary market (e.g. manufacturing establishment for running shoes) - Specialized: developed on purpose for that kind of innovation (e.g. drug distribution system) - Co-specialized: something in the middle (e.g. containerized shipping, where both the container ships and the ports that receive them must be customized to make such shipping feasible) In weak appropriability contexts with dominant design: - Generic asset investments reversible and easily imitated, generate no rents. - Specialized assets necessary for exploitation of innovation, generate rents. Examples: commercialization of university inventions and independent inventors. The specialized & complementary assets are the knowledge and ability of how to commercialize the invention, whereas the main asset possessed by the university is the patent and some tacit knowhow. Research strategy How much (basic) research should a firm undertake? (the one that is far away from the market) Especially relevant for research with wide and uncertain application: - Associated spillovers (reduce your appropriability) - Uncertain appropriation - Long-term pay-off Given those characteristics, basic research is mostly conducted by large, established, diversified multi-product firms with market power (IBM, AT&T before divestiture, DuPont, Dow Chemical, Eastman Kodak, Alphabet, Microsoft, etc.) - More likely to benefit from long-term pay-off - First-mover advantage - Basic research can solve applied problems Biotechnology sector (massive presence of small firms) is an exception, discoveries closer to commercialization and patents very effective protection, so less need for size. Open innovation (doesn’t mean free) It means to shift towards use of knowledge external to the firm Open innovation strategy: “a paradigm that assumes that firms can and should use external ideas as well as internal ideas (they are complementary, not substitute), and internal and external paths to market, as the firms look to advance their technology” (Chesbrough, 2006). Empirical evidence suggests that innovation from external sources is important for innovating firms But assimilating ideas and inventions requires effort and good management Open innovation often managed via use of proprietary systems, e.g. patents In a survey of manufacturing firms described (Arora et al., 2016), half of innovating manufacturing firms reported that their most important new product was originated from external sources: (what are these external sources?) customers, suppliers, or outside technology specialists such as universities, independent inventors, and R&D contractors. There was little variation in this share across industries (differently from R&D), although the relative importance of the different external sources varied. A range of their evidence points to the conclusion that customer sourced innovations are more incremental and less valuable, and that the innovations sourced from specialists are the most valuable and require the greatest further investment. Although superficially the term “open” suggests such things as “open source” in software or “open access” in web publications, open innovation is often managed via the use of proprietary systems, namely patents. Acquisition of innovative firms specifically includes their IP portfolio. Licensing of IP associated with innovative ideas is widespread. Firms still choose to patent discoveries that are part of their core technologies. However, firms such as IBM and Intel also maintain in-house technical journals that publish discoveries that either may not be patentable or are part of the technology knowledge base that they know will become generally known anyway. By publishing these discoveries, they preclude other firms from trying to patent them, and at the same time reduce their patenting costs. Make or buy? Make or buy new technology needed to pursue particular strategic choices? - Purchase of new technology often in form of purchase of firm that owns it. - Acquisitions can be difficult to assimilate within existing firm; risk loss of human capital from acquired firm via exit of key employees Factors influencing decision: - Importance of speed if technology exists externally but would have to be developed in-house. - How closely linked it is to the firm’s own core competencies. - IP rights associated with technology Large firms tend to combine external and internal knowledge acquisition strategies, small firms tended to specialize in one or the other (Cassiman and Veugelers, 1999). Transaction cost theory (Williamson 1979) Transaction cost theory: costs surrounding a transaction determine whether it takes place within firm or it is transacted in markets. Assumptions: - Contracts incomplete, need for renegotiation over time - Uncertainty surrounding the transaction process and outcome - Need for one of the parties to make sunk investment in transaction-specific assets. Creates incentives for opportunistic conduct Insight: transaction that is more at risk of opportunistic conduct is more likely to move inside the firm to align interests of both parties. Application to innovation: most R&D conducted in-house Or collaborate? Alternative option to make or buy: collaboration via - Strategic alliance - Joint venture (work on a common project) - Technology licensing - Collective research organization Advantages: - Increased flexibility - Speed - Risk sharing - Knowledge exchange - Create new knowledge that would have been difficult to create solo. Disadvantages: - Value capture challenging - Firms potentially reluctant to reveal the most valuable part of their knowledge to collaborator, reducing effectiveness of collaboration Collaboration for innovation is one of the pillar of EU Goods with network effects Static analysis In static analysis of market with network effects, network effects do not create network externality (short point of view) Example: many non-integrated firms competitively supplying hardware and software. If customers myopic (do not evaluate future supply of software for their hardware choice), one consumer’s purchase decision has no effect on another consumer’s welfare. No network externality, normal market with complementary goods. (network effects create no externalities à my decision don’t influence others) Goods with network effects Dynamic analysis Technology adoption decision depends on expectations about other people's future decisions. Creates network externality where one person’s demand increases if another person purchases the technology. Consumers’ expectations of network size (consumers) matter. Consumer has multi-period purchase decision (with varying quantity across consumers). Example hardware and software: - Consumers choose hardware in first period and are then “locked-in” via sunk costs; - Quantity of hardware sold in first period signals future price of software (larger hardware base implies lower marginal cost, lower price, and greater variety of software); - Linkage increases elasticity of demand for hardware and results in indirect network externality. Network externalities in systems competition can lead to underutilization and delayed adoption if consumers fear lock-in and wait for winning hardware. Ex post markets subject to consumer lock-in (e.g. Fortran in mission-critical applications). Goods with network effects Competition among systems When standards are important to consumers, competing systems with different standards behave like network goods. When market share of a competing system gets large, increased consumer demand leads to increasing returns effect. Results in intense competition among systems manufacturers. Success of any system strongly influenced by consumers' adoption decisions, which depend on their expectations of which system will win. But consumer heterogeneity and inertia will limit standardization. A good example of this is the survival of two main personal computer and, more recently, mobile telephony systems, one closed (Apple) and one open (Windows computers and Android phones) This survival is obviously partly attributable to consumer inertia, in the sense that once using a system, it is difficult to switch from one to the other. The survival of the two systems is also due to differing customer tastes for flexibility in use and willingness to interact with the details of software maintenance. A closed system greatly reduces the number of unexpected problems that can arise when new hardware or software is connected to it, but it also limits the kinds of hardware and software that can be installed on the system. Strategies for network competition: To induce adoption Firms need to signal to consumers that they will not be stranded with a defunct network (incentivize to step in, to adopt the technologies). Example: if firm owns both hardware and software, network effects internalized and hardware price can be lowered to induce purchase (e.g. Nintendo, Sega, Atari). Hardware only firm can use penetration pricing for hardware with discounts to early adopters, or rent hardware rather than selling. Signal survival by means of reputation, advertising, sunk costs of investment in system (e.g. IBM’s entry in PC market). Second sourcing (e.g. open source software in computer industry) Strategies for network competition: To create or break lock-in Induce lock-in of consumers through switching costs: - Contracts for service or parts - Costs of data conversion (proprietary data formats) - Loyalty and preferred customer programs Break lock-in of consumers to encourage adoption: - Rebates to buyers turning in old equipment or competitive upgrades - Free training in the new standard - Provision of “gateway technology” (induced compatibility among networks) Summary - Goal of firm-level innovation is value creation and capture. - Strategy involves understanding where an industry is in its life cycle, and whether a firm is a startup, young, or established. - Established firms need to learn to adapt to radical and architectural inventions and to understand their implications for organization of own research. - Start-ups capture value from radical and architectural innovation through appropriation in form of IP and complementary assets. - Different technologies may favour different make or buy or collaborate decisions. - Platform technologies require choosing level of compatibility with other platforms and ensuring platform survival. 14/10/2024 PATENT STATISTICS, INNOVATION INDICATORS AND INNOVATION SURVEYS FOR ECONOMETRIC ANALYSIS (Lecture 9 by Gloria Di Caprera) Applied part of the course Measures of Innovation Two main traditional measures of innovation are R&D expenditures and patents. R&D expenditures: regularly collected, usually on an annual basis, in R&D surveys since the 1950s in many countries (OECD, 2002); Patents: (make money out of an idea) 19th century, linked to the development of intellectual property rights and the institution of national patent offices. However, R&D only measures the input of the innovation process and patents only cover innovation which is sufficiently new and worth to be patented A third source of innovation indicators widely used: Innovation Surveys (are both an input and an output) Innovation surveys: - They provide Qualitative and Quantitative data on innovation activities; - Extensively used by statisticians, econometricians and policy makers; - Used as benchmark and monitor for innovation performance. Innovation Surveys OSLO manual (OECD, 1992,1996,2005) provides: - definition of what is meant by innovation; - the different ways in which enterprises can innovate; - measures of the input side (R&D expenditure) as well as output side (patents); - summarize sources, effects, obstacles and modalities of innovation. Today, the majority of countries conduct IS (each one have different regulation, …, so they have different answer), in Europe they are known as Community Innovation Surveys (CIS) Structure and content of innovation Surveys The OSLO manual provides: a) Indicators of Innovation outputs: the introduction of new products and processes; percentage of sales; share of products at various stages of the product life-cycle; b) Wider range of innovation and R&D expenditures: acquisition of patents and licences, product design, market analysis; c) Information about Innovation: sources of knowledge, reasons for innovation, partners and research cooperation. Most important IS for Italy is ISTAT Characteristics of Innovation Survey data Most of the data collected in innovation surveys are qualitative (answers to questions in words), subjective, and censored; They are taken from stratified samples (where the strata are generally defined in terms of size and industry, and sometimes regions); They come in waves of cross-sectional data (a wave of data is a year; cross-sectional data is given by the fact that an individual/a firm is interviewed overtime in different waves) Most of the data from the innovation surveys are qualitative, that is, discrete: Dichotomous (binary) (answer like yes or no to be easy to read and answer) Ordered categorical (1,2,3,4,…) or unordered categorical (2,4,1,5,…) Qualitative data are less informative than quantitative data but can be less affected by measurement errors. Censored Variables: collected only for a subset of the firms (cluster) in the overall sample (ex. Innovation expenditures and innovation output). Subjective data: of a subjective nature, being largely based on the personal appreciation and judgment of the respondents. Determinants of Innovation Innovation surveys have also been used to identify the determinants of innovation. The exact definition of innovation may vary across studies. The Oslo Manual (OECD, 2005) distinguishes four types of innovations: - product innovations: new goods or services or significant improvements in existing ones; - process innovations: changes in production or delivery methods; - organizational innovations: changes in business practices, in workplace organizations or in the firm’s external relations; - marketing innovations: changes in product design, packaging, placement, promotion, or pricing. Measuring Innovation While innovation is considered to be the engine of economic growth, measuring innovation is not easy. it is subjective and difficult to provide an overall picture of innovation in a continuous manner (that’s why we have IS). R&D expenditure is often used as a proxy (variable of approximation) for innovation or technological progress. However, expenditure is an input for R&D rather than an output of R&D, which should be innovation. Total factor productivity (TFP), but again, TFP is affected by factors other than innovation. Measuring Innovation - Patent Statistics Patent information is increasingly used to analyse innovation and the innovation process, and patent statistics are increasingly used as a measure of innovation. The reasons for the increasing use of patent data in recent years are twofold. 1. A patent database for the analysis of innovation has been developed. The seminal one is the National Bureau of Economic Research (NBER) patent database. Similar databases have been constructed by the OECD, European Patent Office (EPO), and Institute of Intellectual Property (IIP) in Japan. 2. High-quality computers and software became widely available. Patent statistics and Innovation activities Innovation can be understood as a process of converting technological or nontechnological inventions, ideas, and knowledge into the new products, services, and processes to generate economic returns; Patents can be an input and an output of this proces

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