Competition, Innovation and Productivity Growth

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Competition, Innovation and Productivity Growth EGAP January-April, 2006

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Purpose of the CourseReview the links between competition, innovation and productivity growth in the long run. From a long-run perspective, one can see that gains from competition-enhancing reforms are likely to exceed static gains observed in the short run since firms will pursue innovation in ways they would not have under regulation that promotes non-competitive conditions and rent seeking behavior. Other relevant issues: i) Measuring welfare gains from product innovation; ii) New modes of competition observed in “dynamically competitive” industries iii) Competition and efficiency in e-commerce, education, and health care; iv) Interactions between product- and factor-market competition.

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Impact of Competition on Prices and Cost Short Run EquilibriumCompetition brings about allocative efficiency gains by forcing price to converge to marginal costpqpaqa πaDemand = Price = Marginal RevenueMarginal CostAverage CostFirms subject to intense competition will take advantage on any opportunity to produce as long as price (mg revenue) exceeds (equals in the margin) mg cost

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Impact of Competition on Prices and Costpqpbqb πbDemand = Price = Marginal RevenueMarginal CostAverage CostIn the absence of market barriers, new entrants will force price downwards reducing above mkt profitspb < paπb < πa

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Impact of Competition on Prices and Cost Long Run EquilibriumpqpcqcDemand = Price = Marginal RevenueMarginal CostAverage CostIn the limit, competition will lead to operate at the minimum costpc < pbπc < πb

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Monopolist's ChoicesDemand, p = f(q)PriceQuantityBecause of its own scale relative to the market, the monopolist is able to determine the market price Marginal Revenue < priceReallocation of inputs to other industriesNet loss to societyTransfers from consumers to producersStatic InefficiencyIncentive to rent seeking behavior

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Purpose of the CourseIn an early study, the costs of static resource misallocation due to lack of competition in the United States were estimated to be much less than one per cent of GNP (Harberger, 1954). However, efficiency gains from competition are not limited to such static and allocative gains Leibenstein contrasted allocative efficiency with so-called “X-efficiency” (Leibenstein, 1966) since extra costs do not mean immediate bankruptcy for a monopolist, they will be slack in cost control and in the effort put in by management and workers. different market structures are associated to different cost structures, higher costs being associated with non-competition. Recent theoretical and empirical studies on gains from competition have been paying increasing attention to “productive efficiency” and “dynamic efficiency”, which can be broadly defined in terms of productivity growth through innovations.

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Purpose of the Course“Productive (or, technical) efficiency” gains come from productivity-enhancing innovations which introduce new and better production methods, and successful innovations will eventually raise the level and growth rate of productivity in the long run (i.e., “dynamic efficiency” gains). Spence (1984) considered the links between market structure and industry performance in terms of both “static allocative efficiency” and “dynamic technical efficiency” channels. The latter channel is usually much more complicated than the former one. Need to review recent studies on the links between competition, innovation and productivity growth in the long run.

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Purpose of the CourseThe positive impact of competition-enhancing polices cannot be fully appreciated by measures of static efficiency gains in the short run. Competition has pervasive and long-lasting effects on economic performance by affecting economic actors’ incentive structure, encouraging their innovative activities, and selecting more efficient ones from less efficient ones over time. In some high-tech industries such as information and communications technology (ICT) sectors, “network effects” and “positive feedback effects” make competition between different systems/networks fierce. Little sign of competition in static measures (concentration ratios, price-cost margin, etc.) might hide vigorous competition in the dynamic sense. New features of dynamic competition for the market (i.e., competition between different systems to become the standard in a new market based on new technology) raise new challenges for policymakers.

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Purpose of the CourseThe claim that market concentration is conducive to innovation is not supported by recent empirical findings. Motivated by the Schumpeter’s conjecture that large firms in concentrated markets have advantage in innovation, many empirical studies have investigated the relation between market concentration and innovation. There is little empirical support for the view that large firm size or high concentration is strongly associated with a higher level of innovative activity. Empirical studies confirm that the link between product market competition and productivity growth is positive and robust. Interactions between the disciplining effect of product market competition and that of competition for corporate control are also found in a few studies. It remains inconclusive, though, whether competitive pressures from the product market and competitive pressures from the corporate governance side are substitutes or complements in enhancing productivity.

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Purpose of the CourseEmpirical findings from policy changes such as regulatory reforms, openness to global competition, introduction of competition into not-for-profit sectors, etc. also confirm that competition brings about productivity gains, consumers’ welfare gains, and long-run economic growth. However, some studies suggest that it could take a long time for the producers and consumers to adjust themselves to the new environment with increased competition and to fully experience efficiency gains. Analyses based on micro data show that firm dynamics (birth and death, growth and decline of individual firms) is a key component of innovation and aggregate productivity growth. Dynamic efficiency gains from product market competition, however, can hardly be achieved without well-functioning factor markets which reallocate labor and capital of shrinking/exiting firms to entering/ growing firms. There exist considerable interactions between product market competition and competition in labor and capital markets.

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Theoretical Issues: Competition and IncentivesPrincipal-agent models under information asymmetry offer some explanation on the role of competition in raising efficiency. Monopoly rents to a monopolistic firm can be captured by its managers (and workers) in the form of managerial slack or lack of efforts. Competitive pressure may reduce such slack by giving more incentives to the stakeholders of the firm (i.e., managers and workers) for increasing their efforts and improving efficiency. Product market competition disciplines firms into efficient operation

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Theoretical Issues: Competition and IncentivesChannels (Nickel et al., 1997). i) Competition creates greater opportunities for comparing performance under information asymmetry and hence makes it easier for the owners or the market to monitor managers ii) Cost-reducing improvements in productivity could generate larger increase in revenue and profit in a more competitive environment where price elasticity of demand tends to be higher. iii) The probability of bankruptcy is likely to be higher in a more competitive environment, which will force managers to work harder to avoid bankruptcy. In the sense that product market rents coming from lack of competition may be shared with workers in the form of higher wages or reduced effort, the degree of competition could also affect the level of workers’ effort in similar ways.

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Theoretical Issues: Competition and IncentivesTheoretical predictions on the effects of competition on incentives are difficult to interpret… In the models of the market mechanism as an incentive scheme under information asymmetry, product market competition among firms can reduce managerial slack so far as there is significant correlation among the firms’ costs due to common exogenous shocks (Hart, 1983). But, by modifying model assumptions about managers’ responsiveness to monetary incentives, Scharfstein (1988) showed that competition might actually exacerbate the incentive problem. Similarly, while higher demand elasticity under competition increases the relative rewards from a cost reduction, bigger scale of operations for a monopolist tend to increase his absolute reward from a similar cost reduction. Depending on the setting of the model, competition is shown to improve efficiency in many, but not all, circumstances.

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Theoretical Issues: Competition and InnovationPotential trade-off between static and dynamic efficiency depends on the link between competition and innovation. Schumpeter (1942): The organization of firms and markets most conducive to solving the static problem of resource allocation (competition) is not necessarily most conducive to rapid technological progress. The positive effects of market power on innovation in his view can be summarized under the following two themes (Cohen and Levin, 1989). The expectation of some form of transient ex post market power is required for firms to have the incentive to invest in R&D. The possession of ex ante market power also may favor innovation. When capital markets are imperfect, the rents from market power provide firms with the internal financial resources for innovative activities. Market power also helps reduce uncertainty associated with excessive rivalry which tends to undermine the incentive to invest. Is competition conducive or detrimental to innovation?

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Theoretical Issues: Competition and InnovationPredictions of theoretical models are mixed about the question on competition and innovation. Schumpeterian view of market power and innovation: competition is rather detrimental to innovation and technological progress If more monopolistic firms are more active in innovative activities because of less market uncertainty and deeper pockets, competitive pressure would reduce their incentives to invest in R&D. Competing view: Competition forces firms to innovate in order to survive. Recent empirical studies report positive correlation between product market competition and productivity growth Aghion and Howitt (1998) offer theoretical cases where competition is indeed conducive to innovation and growth: Darwinian effect Neck-and-neck competition Mobility effect

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Theoretical Issues: Competition and InnovationDarwinian effect: Intense product market competition forces managers to adopt new technologies to avoid loss of control rights due to bankruptcy (Aghion et al., 1999) Firms should innovate to survive under competitive pressure (Porter, 1990). Neck-and-neck competition: In a model of “creative destruction”, the incumbent firms unlike new entrants have no incentives to innovate. With incumbent firms engaged in step-by-step innovative activities, competition could increase innovation more intensive product market competition between firms with “neck-and-neck” technologies will increase each firm’s incentive to acquire or increase its technological lead over its rivals.

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Theoretical Issues: Competition and Innovation Mobility effect: In the learning-by-doing model of endogenous growth, the steady-state rate of growth may be increased if skilled workers become more adaptable in switching to newer production lines. In this case, more competition between new and old production lines (parameterised by increased substitutability between them) will induce skilled workers to switch from old to newer lines more rapidly (Aghion and Howitt, 1996).

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Theoretical Issues: Competition and SelectionFirm dynamics (i.e., birth and death, growth and decline of individual firms) make an integral part of dynamic competition. Theoretical & empirical studies focused on firm-level or plant-level dynamics show that aggregate productivity of an industry is significantly affected by compositional changes in the industry due to firm dynamics Dynamic competition incessantly weeds out less efficient firms from more efficient ones and reallocates productive resources from shrinking/exiting firms to entering/growing firms. In this context, well-functioning labour markets and capital markets are very important

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Theoretical Issues: Competition and Selection“creative destruction” as a theoretical framework for dynamic competition and firm dynamics Dynamic competition: process in which innovators with new technology enter a market and compete with incumbents with conventional technology. If the innovation is successful, the entrants will be able to replace the incumbents. If not, they will fail to survive. Indeed, such dynamic competition “from the new commodity, the new technology, the new source of supply, the new type of organisations” strikes “not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives” (Schumpeter, 1934).

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Schumpeter's Creative DestructionProcess of industrial transformation that accompanies radical innovation. Innovative entry by entrepreneurs is the force that sustains long-term economic growth, even as it destroyed the value of established companies that enjoyed some degree of monopoly power. Companies that once revolutionized and dominated new industries have seen their profits fall and their dominance vanish as rivals launched improved designs or cut manufacturing costs. Creative destruction may also push an industry to a monopoly situation. Successful innovation is normally a source of temporary market power, eroding the profits and position of old firms, yet ultimately succumbing to the pressure of new inventions commercialized by competing entrants. Creative destruction is a powerful economic concept, it can explain the dynamics of industrial change: the transition from a competitive to a monopolistic market, and back again. It has been the inspiration of endogenous growth theory and also of evolutionary economics. Unfortunately for some, creative destruction can hurt. Layoffs of workers with obsolete working skills sometimes signal these new innovations. Though they allow more workers to be available for more creative, and productive uses, they can cause severe hardship in the short term.

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Schumpeter's Creative DestructionThere are numerous types of innovation generating creative destruction in an industry: New markets, products or equipment New sources of labor and raw materials New methods of organization, management, or methods of inventory management New methods of transportation or communication (e.g., the internet) New methods of advertising and marketing New financial instruments and/or scams

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Theoretical Issues: New modes of CompetitionIn high-tech industries (such as ICT) where tech. changes are very rapid and competition centres on Schumpeterian innovation, “dynamic” competition for the market is more important than static price/output competition in the market (Besen & Farrell, 94; Evans & Schmalensee, 2001) In the static sense, competition in such industries appears limited A few dominant firms have significant market power and they set prices well above marginal costs. In the Schumpeterian view, however, the expectation of short-run market power is a necessary condition for dynamic competition and the existence of short-run market power does not necessarily imply lack of competition. Key characteristics of ICT industries include: low marginal costs and high fixed costs; existence of scale economies and network/system effects; winner-take-all races in innovation; and high profits for industry leaders (Evans and Schmalensee, 2001). In such industries, competition between different systems/networks to become the standard in the market is fierce

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Theoretical Issues: New modes of CompetitionKeywords in understanding new features of dynamic competition Network effects/ positive feedback effects/ systems competition Network effects users want to buy products which are compatible with those bought by others because the value of a product is an increasing function of the size of the network of compatible products (Katz and Shapiro, 1994). Network effects are pervasive and take different forms: Direct network effects: found in communications networks (e.g., telephone, fax, mobile phone, etc.). Extreme case, a fax machine would be of no use if one’s counterparts do not have a compatible fax machine. Indirect network effects: found in a system of hardware/software. A larger base of hardware owners implies a larger market for compatible software products. If software production has scale effects, consumers belonging to a larger network of a hardware/software system will be able to buy software at a lower price and they will also have more variety in choosing software products. In general, indirect network effects exist in any situation where the availability of complementary goods increases as the number of users of the good increases. Systems competition based on such effects is observed in: computer hardware and software; credit-card networks; durable equipment and repair services, and the typewriter keyboard

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Theoretical Issues: New modes of CompetitionWhen more than one network are competing with one another, buyers want to get more benefits from network effects by joining a larger or winning network. Therefore, a larger network has advantage in competing with smaller ones and hence can grow even faster. In other words, network effects create “positive feedback effects” or “snowball effects”. History & expectations matter in systems competition (Besen and Farrell, 1994). As buyers want compatibility with the existing standard system/network, better products that arrive later may be unable to displace the existing one with lower quality but with a broader base. Buyers’ purchase decisions are also strongly influenced by expectations of the future network size. Systems that are expected to be popular will be more popular for that reason. As perceptions and expectations can play a crucial role, strategies and tactics are important in systems competition.

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Theoretical Issues: New modes of CompetitionIn systems competition characterised by strong network effects and positive feedback effects, the coexistence of incompatible products tends to be unstable and the winning standard can easily dominate the whole market. The VHS videocassette system and the Beta-max system coexisted only temporarily. In such markets the winners take all. Once one system becomes the standard, it is very difficult to change the standard. Small differences (either in reality or in perception) can give disproportionately large gains to the winning system. Systems competition tends to be extremely fierce.

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Last Updated: 8th March 2018

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