“Competition, Imitation and Growth with Step-by-Step Innovation,” P. Aghion, C. Harris, P. Howitt, & J. Vickers (2001)

(One quick PSA before I get to today’s paper: if you happen, by chance, to be a graduate student in the social sciences in Toronto, you are more than welcome to attend my PhD seminar in innovation and entrepreneurship at the Rotman school which begins on Wednesday, the 7th. I’ve put together a really wild reading list, so hopefully we’ll get some very productive discussions out of the course. The only prerequisite is that you know some basic game theory, and my number one goal is forcing the economists to read sociology, the sociologists to write formal theory, and the whole lot to understand how many modern topics in innovation have historical antecedents. Think of it as a high-variance cross-disciplinary educational lottery ticket! If interested, email me at kevin.bryanATrotman.utoronto.ca for more details.)

Back to Aghion et al. Let’s kick off 2015 with one of the nicer pieces to come out the ridiculously productive decade or so of theoretical work on growth put together by Philippe Aghion and his coauthors; I wish I could capture the famous alacrity of Aghion’s live presentation of his work, but I fear that’s impossible to do in writing! This paper is based around writing a useful theory to speak to two of the oldest questions in the economics of innovation: is more competition in product markets good or bad for R&D, and is there something strange about giving a firm IP (literally a grant of market power meant to spur innovation via excess rents) at the same time as we enforce antitrust (generally a restriction on market power meant to reduce excess rents)?

Aghion et al come to a few very surprising conclusions. First, the Schumpeterian idea that firms with market power do more R&D is misleading because it ignores the “escape the competition” effect whereby firms have high incentive to innovate when there is a large market that can be captured by doing so. Second, maximizing that “escape the competition” motive may involve making it not too easy to catch up to market technological leaders (by IP or other means). These two theoretical results imply that antitrust (making sure there are a lot of firms competing in a given market, spurring new innovation to take market share from rivals) and IP policy (ensuring that R&D actually needs to be performed in order to gain a lead) are in a sense complements! The fundamental theoretical driver is that the incentive to innovate depends not only on the rents of an innovation, but on the incremental rents of an innovation; if innovators include firms that already active in an industry, policy that makes your current technological state less valuable (because you are in a more competitive market, say) or policy that makes jumping to a better technological state more valuable both increase the size of the incremental rent, and hence the incentive to perform R&D.

Here are the key aspects of a simplified version of the model. An industry is a duopoly where consumers spend exactly 1 dollar per period. The duopolists produce partially substitutable goods, where the more similar the goods the more “product market competition” there is. Each of the duopolists produces their good at a firm-specific cost, and competes in Bertrand with their duopoly rival. At the minimal amount of product market competition, each firm earns constant profit regardless of their cost or their rival’s cost. Firms can invest in R&D which gives some flow probability of lowering their unit cost. Technological laggards sometimes catch up to the unit cost of leaders with exogenous probability; lower IP protection (or more prevalent spillovers) means this probability is higher. We’ll look only at features of this model in the stochastic distribution of technological leadership and lags which is a steady state if there infinite duopolistic industries.

In a model with these features, you always want at least a little competition, essentially for Arrow (1962) reasons: the size of the market is small when market power is large because total unit sales are low, hence the benefit of reducing unit costs is low, hence no one will bother to do any innovation in the limit. More competition can also be good because it increases the probability that two firms are at similar technological levels, in which case each wants to double down on research intensity to gain a lead. At very high levels of competition, the old Schumpeterian story might bind again: goods are so substitutable that R&D to increase rents is pointless since almost all rents are competed away, especially if IP is weak so that rival firms catch up to your unit cost quickly no matter how much R&D you do. What of the optimal level of IP? It’s always best to ensure IP is not too strong, or that spillovers are not too weak, because the benefit of increased R&D effort when firms are at similar technological levels following the spillover exceeds the lost incentive to gain a lead in the first place when IP is not perfectly strong. When markets are really competitive, however, the Schumpeterian insight that some rents need to exist militates in favor of somewhat stronger IP than in less competitive product markets.

Final working paper (RePEc IDEAS) which was published in 2001 in the Review of Economic Studies. This paper is the more detailed one theoretically, but if all of the insight sounds familiar, you may already know the hugely influential follow-up paper by Aghion, Bloom, Blundell, Griffith and Howitt, “Competition and Innovation: An Inverted U Relationship”, published in the QJE in 2005. That paper gives some empirical evidence for the idea that innovation is maximized at intermediate values of product market competition; the Schumpeterian “we need some rents” motive and the “firms innovate to escape competition” motive both play a role. I am actually not a huge fan of this paper – as an empirical matter, I’m unconvinced that most cost-reducing innovation in many industries will never show up in patent statistics (principally for reasons that Eric von Hippel made clear in The Sources of Innovation, which is freely downloadable at that link!). But this is a discussion for another day! One more related paper we have previously discussed is Goettler and Gordon’s 2012 structural work on processor chip innovation at AMD and Intel, which has a very similar within-industry motivation.

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