Economics of Innovation PDF

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Economics of Innovation LECTURE 1 INTRODUCTION Aims • Applying economic analysis to better unverstanv the importance of innovation to companies anv the economy • Developing theoretical builving blocks for the analysis of innovation, while applying these towarv unverstanving empirical issues surrounv...

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Economics of Innovation

LECTURE 1 INTRODUCTION Aims • Applying economic analysis to better understand the importance of innovation to companies and the economy • Developing theoretical building blocks for the analysis of innovation, while applying these toward understanding empirical issues surrounding innovation and its impact - Today innovation is ubiquitous (everywhere)

1. Why innovation matters? At a macro level: innovation is key to growth, development and competitiveness “Much of the rise in living standards is due to innovation —this has been the case since the Industrial Revolution. Today, innovative performance is a crucial factor in determining competitiveness and national progress. Moreover, innovation is important to help address global challenges, such as climate change and sustainable development” OECD (2007) Innovation is often directly connect t building knowledge-based capital At a micro level: “Innovate or Die”

2. What do economists say about innovation? “the invention of all those machines by which labour is so much facilitated and abridged seems to have been originally owing to the division of labour” “The bourgeoisie cannot exist without constantly revolutionising the instruments of production, and thereby the relations of production, and with them the whole relations of society.” - in Marxist contexts) the capitalist class who own most of society's wealth and means of production. “The gratification of a want or a desire is merely a step to some new pursuit. In every stage of his progress he is destined to contrive and invent, to engage in new undertakings; and when these are accomplished to enter with fresh energy upon others.” “Invention is the mother of necessity.”

“(the) process of industrial mutation …. that incessantly revolutionises the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of creative destruction is the essential fact about capitalism.” “Path dependency and the economics of QWERTY” • Adam Smith • John Stuart Mill • Alfred Marshall • Thorstein Veblen • Robert Solow • Paul David • Richard Nelson …. Economists who agree with said quotes ^

3. What is innovation? Innovations transform (and hopefully improve) ‘things’ and ‘ways of doing things’… CHEAPER AND/OR BETTER

3.1The Linear Model of Innovation • •

Linear: A line of interconnections from Research/Creativity to Invention to Design/Development to Innovation Simplified model; No feedback loops

Research and creativity  Invention  Design and development  innovation However… Innovation is rarely a linear process but a non-linear complex process

3.2Innovation as the ‘successful’ exploitation of new ideas

Invention v.s Innovation

• • • •

Goodyear invented vulcanized rubber, but did not create Goodyear Tyres; Howe invented the sewing machine, but Singer later infringed the patent; Spangler invented the vacuum cleaner , but Hoover was first to commercialise it; Paterson developed DOS, but Gates bought the rights ($25,000!) & licensed it to IBM.

Innovation = ‘successful exploitation’ of new ideas • • • •

Innovation ≠ invention: not necessarily something new “Too often the obsession is with inventing something totally unique rather than extracting value from the creative … ” (William Buxton, 2005) Could be a fresh perspective on something that already exists “I invented nothing new. I simply assembled the discoveries of other men behind whom were centuries of work…Progress happens when all the factors that make for it are ready and then it is inevitable.” (Henry Ford)

KEY TAKEAWAYS 1. Innovation matters! This course provides an economic lens to understanding innovation activities and their impact. 2. There are an array of perspectives in the history of economic thought on innovation issues, which will be explored in depth in the rest of this course. 3. Innovation is the successful exploitation of new ideas. 4. The linear model of innovation is a useful tool to describe the process but the reality is far more complex and non-linear.

LECTURE 2 BASIC CONCEPTS OF INNOVATION Lecture Outline 1. Different Types of Innovation 2. Process Innovation & Cost Conditions 3. Product Innovations & the Characteristics Approach Aims 1. Appreciate the definitional issues of innovation types and describe key differences using examples 2. Understand the impact of process innovations in different scenarios based on cost conditions 3. Applying the characteristics approach, WTP and PTM, describe the impact of product innovations 1. Different types of Innovation ’’Introducing new commodities or qualitatively better versions of existing ones; finding new markets; new methods of production and distribution; or new sources of production for existing commodities; or introducing new forms of economic organisation’’ – Schumpeter, 1954. 1.1 Product vs. Process Innovation  Product Innovation : It creates a new or improved product (either a good or a service) for sale without any change in the production process  Process Innovation: It changes the way in which a product is made, without changing the product itself Product Innovations: o The novelty of a new product will often persuade customers to make purchases – expand market share of the company Example - Dyson’s vacuum cleaners • Dual Cyclone Technology • Powerful suction • Bagless • UK Market share rose from 0 - 46% in 15 years

Service Innovations (as product Innovations)

  

As the service industry grows, service innovations assume more importance New forms of service applications – competitive distinction by producers: less tangible, e.g. low cost airlines, Facebook, Airbnb, online banking, Uber Not just by service providers but also increasing trend of servitisation of manufacturing firms

Process Innovations Increases the efficiency of a process and makes it cheaper- direct implications for productivity   

Technological process innovations (improved equipment) Production management innovation: e.g. lean production, Just in time, FMS, etc. Examples: implementation of computer-assisted design for product development, GPS tracking for transport services

Process Innovations as a Cost Saver Assembly line as a process innovation at Ford Motors in 1913

A s s e m b ly T im e

C ra ft M ass R e d u c t io n p r o d u c t io n , p r o d u c t io n , in e f f o r t 1913 1914 (% ) ( m in s ) ( m in s ) E n g in e 594 226 62 M a g n e to 20 5 75 A x le 150 2 6 .5 83 C o m p o n e n ts 7 5 0 93 88 in t o v e h ic le Ford’s Model T sold for $850 in 1908 , $600 in 1913 and $360 by 1916 thanks to cost reduction due to process innovations Source: Womack, J. P., D. T. Jones, and D. Roos (1990) The Machine That Changed the World, Rawson Associates/Scribner

Other Innovations

o Marketing innovation (e.g. design, packaging, pricing, promotion, new markets, new positioning of products) o Organisational innovation (e.g. a new organisational method, workplace organisation or external relations, new collaboration, new organisational model) o Business model innovation - a simplified representation of how the business makes money (e.g. IBM, Dell’s new distribution model) 1.2 Architectural vs. Modular Innovation  

Architectural innovation: system-level reconfiguration of different parts with basic components little changed (e.g. hospital, car) Modular innovation: mutation in elements that go into a system (e.g. car engine, brakes, airbags)

1.3 Incremental vs. Radical Innovation (Business as usual vs. Business torn apart!)  

Incremental Innovation (Continuous innovation): a steady stream of improvements to a particular product/process which do not change the character in any fundamental way Radical Innovation (Disruptive/Discontinuous Innovation): improvements that fundamentally alter the character of a product/process. They completely undermine the competence of current market leaders

2. Process Innovation & Cost Conditions 2.1 Reduced Fixed Cost No change in marginal costs  

EXAMPLE:

Capital-saving innovation Example: reduction in the cost of a capital equipment (e.g. PC)

An example: microprocessor innovations in computing (Moore’s Law)

Effect on Total Cost

Effect on Average Cost

Process Innovation & Cost Conditions A

C1 C2

2.2 Reduced Marginal Cost No change in fixed costs

B

Q2

Q1

 

Input-saving innovation Example: Division of labour

Marginal Cost Reducing Innovation: E.g. Using recycled denim for insulation

Effect on Total Cost

Effect on Average Cost

C1 C2

A B

Q1

Q2

Process Innovation & Cost Conditions 2.3Reduced Marginal Costs; Increased Fixed Cost  

Capital-intensive process Example: introduction of machinery to replace manpower

(self check in for airports or e-ticket machines at train stations)

Capital-intensive Process

Process Cost

Innovation & Conditions

2.4 Marginal

Reduced Cost (of an additional

model), Increased Fixed Cost  Flexible Manufacturing System (FMS) (e.g. Toyota)

Reduced Marginal Cost (of an additional model), Increased Fixed Cost

3. Product Innovations & the Characteristics Approach    

A pure PI creates a new or improved product without any change in the production process, allowing for changes in inputs (e.g. labour, machine time and materials) Product as a collection of features or characteristics Vertical vs. horizontal differentiation Product Innovations of differing degrees: o Improvement of one characteristic o Improvement of several characteristics o Introduction of one new characteristics o Introduction of many new characteristics =>>> completely new product

The Characteristics Approach Vertical vs. horizontal differentiation   

When two products are vertically differentiated one is unambiguously better than the other When two products are horizontally differentiated they are different but one is NOT superior to the other (it depends on one’s taste) Vertical differentiation easier to analyse

Willingness-to-pay (WTP)

Process and Product Innovations

How do Innovations Change the PTM? C

C

Product Territory Map Price

Product Innovation

B

C

Product

B

A

A

B2 Innovation B1 Process Innovation

Quality

Before Innovation

A

Process Innovation

A

0

B B

C C Slope of WTP Line

KEY TAKEAWAYS 1. There are a wide array of innovation types. Different adjectives may be applicable to the same innovation outcome, but the distinction is, nonetheless, an important one. 2. Process innovations tend to lead to cost reduction with differing effects dependent on cost conditions. 3. The impact of both process and product innovations can be analysed using the WTP curve and PTM.

LECTURE 3 INNOVATION, DEMAND AND CONSUMPTION Aims 1. Define the diffusion of innovation using appropriate examples 2. Describe the process and drivers of innovation diffusion using the Model of Technology Adoption Lifecycle and/or the diffusion curve 3. Understand the distinctive roles of different types of consumers in innovation diffusion and consumption 1.1 What is the Diffusion of Innovation  Diffusion is the process by which innovations are adopted and used by consumers, or other organisations  Diffusion rate is the relative speed at which innovations are adopted  Whether a product or process, it may take a long time for an innovation to diffuse across users/consumers  The speed matters! 1.2 Model of Technology Adoption Lifecycle by Everett Rogers

Percentage of customer/user groups

1.3 Diffusion Curve: ‘Epidemic’ Models

Diffusion of Various Innovations: An Example

1.4 Product Life Cycle (PLC) Model

1.5 Drivers of Diffusion/Adoption •

Price and quality effects (Moore’s Law revisited: microprocessor innovations in computing)

•

Supply-side factors, e.g. availability, improved info transfer, production technology Income, firm size Strategic decisions Bandwagon effects Government regulation, intervention (fiscal incentives) Other consumer-side characteristics (e.g. preference, taste)

• • • • •

1.6 Innovation and Learning Consumers • • •

Recognition that something is an acquired taste and a taste worth acquiring Demand grows as consumers acquire the taste – learn how to appreciate the product/service Educating is an important consideration when it comes to promoting innovations at early stages to learning consumers

2. The Demand for Innovation Economics background • •

Consumer preferences: consumers rank different bundles of goods/services according to levels of utility/satisfaction afforded, with diminishing marginal utility Demand function: estimating how the demand for each good depends on the prices of all goods and on individual incomes (Economics and Consumer Behaviour, Deaton and Mullebower, 1980)

From a producer-centric view…

“Therefore in 1909, I announced one morning …. that in the future we were going to build only one model, that the model was going to be "Model T“, and that the chassis would be exactly the same for all cars, and I remarked: Any customer can have a car painted any colour that he wants so long as it is black.“ --- Autobiography by Henry Ford

Six types of Consumer: • • • • • •

Economic Consumer Veblen/Bourdieu Consumer Marshall Consumer Douglas Consumer Galbraith Consumer Routine Consumer

2.1 Economic Consumer • • • • • •

Fixed, pre-determined wants, which the consumer knows in detail If all were economic consumers there would be little market risk in innovation A skilled optimiser but asocial (consumes in private) Given same prices and income, (s)he will never vary consumption Interested in innovations that reduce price or enhance feature(s) of a good/service that (s)he values Otherwise, not interested in innovation

2.2 Veblen/Bourdieu Consumer 

Thorstein Veblen’s concept of ‘conspicuous consumption’

“With the greater part of rich people, the chief enjoyment of riches consists in the parade of riches, which in their eye is never so complete as when they appear to possess those decisive marks of opulence which nobody can possess but themselves…” - Adam Smith   

Signalling power of consumer purchases: V consumers desire distinction through visible consumption of expensive items Bourdieu consumers are similar, but seek distinction with more modest expenditure Signalling is often more complex than displaying wealth

Nike making an appeal to Veblen consumers with their customised shoes ‘Express your identity’ - CREATE YOUR OWN NIKE FREE iD However close to barefoot you like your run to feel—your reasons are exclusively your own. Run Free, your way.

2.3 Marshall Consumer  

M consumers interested in what innovations can do for them, but not uncritical in their consumption of innovations (c.f. von Hippel, 2005) Von Hippel’s work on democratic innovation

Marshall Consumer – the Creative Consumer

2.4Douglas Consumer • • •

“the real moment of choosing is ... choice of comrades and their way of life” (Douglas, 1983) Consumption of goods as a way of associating with ‘comrades’

• •

Cautious about consuming innovations that might seem to cast doubt on their peer group loyalty And if the group leader adopts an innovation, then other D consumers may follow rapidly

2.5Galbraith Consumer •

• • • •

“As a society becomes increasingly affluent, wants are increasingly created by the process by which they are satisfied …. producers may proceed actively to create wants through advertising and salesmanship. Wants thus come to depend on output.” (Galbraith, 1958) Mass market and advertising Informative vs. persuasive advertising G consumers need encouragement from marketers to give innovations a try

2.6Routine Consumer       

Does not optimise Not influenced by advertising Does not seek distinction Does not seek novelty Not influenced by peer pressure Just sticks to familiar and ordinary consumption items Highly suspicious of innovations

2.7Other Types of Consumer Ethical consumer • Green consumer o Consumption choices with reference to effects on sustainability • Ruskin consumer o Consumption choices with reference to effects on producing labour

2.8Different Types of Consumers & Diffusion Curve Can you match different stages of innovation diffusion and types of consumers

Market Research: •

Market research only makes sense with a small minority of these consumer types: o Economic consumers o Marshall consumers o Routine consumers

•

For the rest, demand is highly contextual o Cannot say whether there is or is not a demand without detailed knowledge of social context

KEY TAKEAWAYS 1. The diffusion of innovation (product or process) is a time-consuming and complex process involving complex interactions with an array of consumers 2. Several models help better understand the process of innovation diffusion/technology adoption 3. There are 6 main types of consumers with distinctive attitudes toward innovation and dissimilar consumption preferences

LECTURE 4 ECONOMICS OF NETWORKS, STANDARDS & DOMINANT DESIGNS 1. Network Effects 2. Standard & Dominant Designs

1. 2. 3. 4. 5.

LEARNING OBJECTIVES Explain different types of network effects Understand the implications of network effects for firms and consumers respectively Using examples describe the significance of different types of standards and the process of them being established Analyse different outcomes of a standards race and the strategies for winning a race Explain why technological Lock-ins take place

What Drives Tomorrow’s Business?

(Source: Tom Goodwin/Wetpaint)

1.1 Definitions  Network effects: When a product or technology exhibits network effects, the value of the product/technology to customers does not only depend on its attributes but also on the network of the customers who use the product Facebook, Instagram, Twitter, Pinterest, Soundcloud, Google, Linkedin etc…

1.2 Network Externality  Positive vs negative externality: the change to the value of the product/service as the size of the network grows

 Positive: commonly seen in mobile network, social media, e.g., among Douglas consumers  Negative: mark of distinction requires not too many others with ownership, e.g., among Veblen/Bourdieu consumers 1.3 Network Effects  Direct Effects: the benefits/costs derive directly from interacting economically or socially with members in the network  Direct externalities typically occur in a physical communications network  Classic example: telephone system  Importance of installed and expected user base Brian Arthur (1989) An individual selects between two rival variants of a new technology product (A and B) by evaluating the payoff (P ) associated with each variant. Payoff at time t is P = Xij + r (njt) where:

(1)

Xij is individual i’s personal preference for technology j r is a term that captures the installed use base The probability of adopting variant A at time t is Pr{ XA...