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Innovation and Competition: Theory, Evidence and Policy for the Great Recession

Innovation and Competition: Theory, Evidence and Policy for the Great Recession. Federico Etro University of Milan, Bicocca Dynamic Competition Lecture Osaka, November 27 2009.

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Innovation and Competition: Theory, Evidence and Policy for the Great Recession

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  1. Innovation and Competition: Theory, Evidence and Policy for the Great Recession Federico Etro University of Milan, Bicocca Dynamic Competition Lecture Osaka, November 27 2009

  2. Analysis of Business creation & R&D in micro- and macro- phenomena- Many issues under a common perspective- Tool of analysis: the Endogenous Market Structures Approach Theoretical principles Empirical evidence Policy applications

  3. Endogenous market structures (EMSs): strategic interactions and endogenous entry (not free entry with perfect competition, but endogenous number of firms due to rational entry in imperfectly competitive markets) wider research on EMSs in: industrial organization (Sutton, 1991, 1998, etc), macroeconomics, trade, innovation & growth industrial and trade policy, macroeconomic policy, contract theory and corporate finance Look at two books..

  4. Advertising!

  5. Traditional approach to market analysis: Structure Conduct Performance

  6. EMS approach to market analysis:

  7. Example to keep in mind • Isoelastic utility: • degree of substitutability • Population of size L • can derive direct (and inverse) demand Di • assume fixed cost F and marginal cost c • Gross profits:

  8. Example to keep in mind • Monopolistic competition à la Dixit-Stiglitz • Optimal mark up: • Number of firms: • Under homogenous goods with zero fixed costs: marginal cost pricing and indeterminacy of the market structure

  9. Cournot competition (homogenous goods) • Equilibrium mark up: • Endogenous entry:

  10. With dynamic entry/exit (Etro-Colciago, 2010, Economic Journal): • Entry and profits are procyclical & mark ups are countercyclical • A Competition Effect helps the propagation of shocks (beyond the neoclassical mechanism): boom > entry > lower markups > higher wages > C and L go up • Steady state EMSs depend on: • Market size, L (and productivity A in general equilibrium) • Entry cost, F • Substitutability, • Bankruptcy rate, • Discounting, r

  11. US (HP) detrended data

  12. VARanalysison US data

  13. Implications for the crisis • Important (supply-side) mechanism of propagation? • Stock market crash > Business destruction > concentration > higher mark ups and lower wages > lower consumption and employment > lower profits … • .. and trade collapse

  14. Test of the market size effects • In the monopolistic competition (Dixit-Stiglitz) approach: • In the EMSs approach (Cournot competition with homogenous goods): • Joint work with Dirk Czarnitzki tests:

  15. Market size vs Number of firms (German NACE 3-digit)

  16. Market size vs Number of firms (German NACE 4-digit)

  17. Trade: the Krugman model • Integration between two equal countries (L=L*) • Optimal mark up: • Number of firms: • Gains from trade = gains from variety

  18. Trade: the Cournot model(with homogenous goods) • Integration between two equal countries (L=L*) • Optimal mark up: • Number of firms: • Gains from trade = gains from competition (lower prices) • See Ghironi and Melitz (2005, QJE) for a dynamic model

  19. Is this only about competition in the market? • or EMSs have something to say about competition for the market?

  20. EMSs and Innovation • When competition is for the market: • Firms decide how much to invest taking into account expected profits and each other‘s • Endogenous entry determines: • Number of investors • Individual investment • Aggregate R&D and rate of technological progress

  21. The simplest example of competition for the market z = probability of innovation V = value of (IPR protected) innovation Quadratic costs of investment Expected profits: EMSs:

  22. what about patentholders? • What is the role of market leaders in investing in R&D and promoting technological progress? • Commonly held view (based on Arrow, 1962): • firms invest more in a competitive market where entry pressure is stronger • incumbents tend to be less innovative than their followers • incumbents do not invest when entry is free • persistence of dominance is signal of market power and lack of entry pressure

  23. Innovation by Leaders • EMSs results: • R&D spending per firm can decrease with entry and when entry is endogenous • incumbents tend to be more innovative than their followers when entry is endogenous (Etro, 2004, Economic Journal) • persistence of dominance is a signal of competition when there is entry pressure • In the above example:

  24. Summing up.... • Two sufficient conditions where incumbent has incentive to invest in R&D and invest more than others • Leadership of incumbent monopolist • Endogenous entry for outsiders in the innovation race Testable hypothesis: Investment of incumbent leader is larger than investment of the average firm when entry is endogenous

  25. Some evidence (from joint work with Czarnitzki and Kraft) • 2005 survey of the Mannheim Innovation Panel • German Innovation Survey since 1992 • German part of the Community Innovation Survey (CIS) • We focus on manufacturing sector • 1,857 firm-level observations

  26. Variables • Dependent Variable: • R&D intensity = R&D/Sales * 100 • Right-hand side: • Incumbent (dummy): a firm that indicates that it is larger than its competitors in main product market (INC) • ENTRY: 4 categories • low to high entry pressure in main product market • Identify incumbents under entry threat: • INC*ENTRY

  27. Other controls • Firm size in terms of employment in t-1 • and its squared value • Capital Intensity (in t-1) = physical assets/employment • 12 industry dummies • Additionally: patent stock (since 1978) as control • higher protection of previous R&D may lead to higher current investment • allows us to use some retrospective data to control for unobserved heterogeneity

  28. Econometrics • We estimate censored regression models, as not all firms invest in R&D • homoscedastic and heteroscedastic models yield same conclusions • We also test for feedback effects from current R&D investment on perceived entry threat, as this would bias the estimates

  29. Table 2: Heteroskedastic Tobit model on RDINT

  30. Support for the EMSs results • Entry threat reduces the R&D investment of the average firm, • but market leaders do invest more in R&D than the average firm, the larger the entry threat is. • Consequently, under these conditions, incumbents are more likely to innovate eventually. • This may explain the persistence of the leadership

  31. Implications for growth • R&D policy to subsidize R&D always (Etro, 2008, Journal Macroeconomics) • International coordination of subsidies to internalize positive spillovers across heterogenous countries (see Alesina, Angeloni & Etro, 2005, American Economic Review)

  32. Implications for the crisis • Need to support R&D Investment through • R&D subsidies and • IPRs protection • Different antitrust attitude toward high-tech leaders

  33. Normative analysis I Suboptimality of EMSs and Dynamic inefficiency • Countercyclical fiscal policyand tax rates (implications for the crisis: supply side-intervention when demand side doesn’t work; see Japanese experience) • Monetary policy aimed at minimizing the impact of price frictions on incentives to invest in R&D and business creation (see Bilbiie, Ghironi & Melitz, 2007, NBERMa)

  34. Normative analysis II • Trade policy: export subsidization always optimal under endogenous entry (Etro, 2010, International Economic Review) Optimal export subsidy: inverse of demand elasticity (opposite of Lerner optimal export tax) • lower in case of imperfect susbtitutabiliy • prohibitive in case of constant or decreasing marginal costs • Is also the equilibrium subsidy when multiple countries adopt it • Implications: Active protectionism may be good! • Exchange rate policy to promote exports • Another case for IPRs protection and R&D subsidies!

  35. EMSs and Competition Policy post-Chicago approach was mainly focused on games with an incumbent and an entrant or a fixed number of firms (exogenous market structures) Ex.: predatory pricing, tying, vertical restraints, mergers… endogenizing entry some results change or need a different interpretation on a general approach: Etro (2006, RAND Journal of Economics; 2008, Economic Journal) on mergers: Davidson-Mukherjee (2007, IJIO), Erkal-Piccinin (2008) on R&D investment and predatory pricing: Kovac-Vinogradov-Zigic (2010, JEDC) on technology transfers: Creane-Konishi (2009, IJIO) on tying and vertical restraints (timing of) entry becomes crucial in antitrust investigations

  36. Tying and EMSs: The Chicago approach (single monopoly profit theorem) associates tying with efficiency reasons The post-Chicago approach to tying starts with Whinston (1990, AER): tying must be anti-competitive when there are a monopolist in the primary market and a duopoly in the secondary market tying strengthens competition > the only purpose of tying is entry deterrence

  37. EMSs analysis of tying: Tying to strengthen competition (reduce prices) is profitable: when there is product differentiation in the secondary market when multiple secondary goods can be bought at the same time when entry in the secondary market is endogenous when demand for the primary good is close to demand for the bundle total welfare increases and consumer surplus is unchanged (with Dixit-Stiglitz demand)

  38. A famous case to keep in mind: Windows-IE The primary market (OSs) is led by Windows the secondary market (browsers) is characterized by: product differentiation (IE, Firefox, Opera, Chrome,..) multihoming (multiple browsers can be tried and used at the same time) endogenous entry (dynamic competitive process with entry of new browsers and expansion of competitors) demand for Windows is close to the demand for the bundle Windows+browser (few want PCs without browser)

  39. A famous case: Windows-IESource: Net Applications Data

  40. Conclusions on Antitrust Endogenous number of firms overturn some results of the post-Chicago approach Entry conditions are crucial to verify an abusive strategy For instance, tying is a normal competitive (price-reducing) equilibrium strategy when the secondary market is characterized by endogenous entry

  41. Final remarks • EMSs are a more realistic representation of real markets: imperfectly competitive • EMSs improve the performance of neoclassical models of business cycle and trade and growth: explaining better the process of business creation and R&D • EMSs provide new implications for macroeconomic policy, trade policy and R&D policy: supply-side intervention • EMSs support many results of the Chicago school: entry regulates dominant firms

  42. ありがとう

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