Market structure and innovation

Overview

Competition be a stronger spur to innovation than monopoly, difference between invention and innovation and process innovation.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why might a monopoly be better placed to innovate than a firm in a competitive market?

   Model answer

   Innovation is expensive, risky and slow to pay back. A monopolist earns supernormal profit, which provides retained earnings to fund research without borrowing and a cushion if a project fails. Barriers to entry mean it can expect to keep the returns from a successful innovation rather than watch rivals copy it, which raises the expected payoff. Its scale also lets it spread research costs over a large output. A firm earning only normal profit has none of these advantages: it has no surplus to invest and no protection for the gains.

2. 2

   Why might competition be a stronger spur to innovation than monopoly?

   Model answer

   Competition supplies the motive that monopoly lacks. A firm facing rivals must innovate to cut its costs below theirs or to differentiate its product, because standing still means losing customers and eventually exiting. A protected monopolist can earn comfortable profits without changing anything, so the incentive to disrupt a profitable existing product is weak, and the effort that competition would channel into innovation can be diverted into defending the barriers instead. Competition also generates variety, because many independent firms try many approaches rather than one firm backing a single research programme.

3. 3

   Explain the difference between invention and innovation.

   Model answer

   Invention is the creation of a new idea, product or process, the technical discovery itself. Innovation is bringing that idea to market successfully: developing it into something that can be produced at a viable cost, financed, marketed and sold. Many inventions never become innovations because no firm can make them pay. The distinction matters for market structure because the two may need different conditions, with small firms and individuals often stronger at invention while the scale and finance needed for commercialisation favour large ones.

4. 4

   What is process innovation, and what does it do to a firm's cost curves?

   Model answer

   Process innovation is a better way of producing an existing product, such as automation, a redesigned production line or improved logistics. It lowers the cost of producing any given output, so the average total cost and marginal cost curves both shift downwards. The lower marginal cost curve cuts marginal revenue at a larger output, so the firm produces more and, where it sets its own price, charges less. In a competitive industry the firm that innovates first earns supernormal profit until rivals copy it and the market price falls.

5. 5

   What is product innovation, and how does it affect a firm's demand curve?

   Model answer

   Product innovation is the creation of a new or improved good or service, or a new variety of an existing one. It shifts the firm's demand and average revenue curve to the right, because more buyers want the product, and makes it steeper and less elastic, because the improvement makes rivals' products poorer substitutes. Marginal revenue shifts with it, so the firm can sell more, charge more, or both, and earn supernormal profit until imitators erode the difference.

6. 6

   How do patents affect the incentive to innovate, and what is the cost of granting them?

   Model answer

   A patent grants the inventor a temporary legal monopoly over the use of an innovation, so imitators cannot free-ride on the research spending. That raises the expected return and makes research projects worth financing which would otherwise be abandoned. The cost is that during the patent period the holder prices above marginal cost, output is restricted and there is a deadweight loss, so society pays for the innovation through higher prices on the protected product. Patent length is therefore a deliberate trade-off between rewarding the innovation and limiting the monopoly it creates.

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