Product Innovation Incentives: Monopoly vs. Competition

• Author: Yongmin Chen,Marius Schwartz
• Date: 01 September 2013
• Published date: 01 September 2013
• DOI: http://doi.org/10.1111/jems.12026

Product Innovation Incentives: Monopoly vs.

Competition

YONGMIN CHEN

Department of Economics

University of Colorado

Boulder CO 80309

yongmin.chen@colorado.edu

MARIUS SCHWARTZ

Department of Economics

Georgetown University

Washington D.C. 20057

mariusschwartz@mac.com

In contrast to Arrow’s result for process innovations, we show that the gain from a product

innovation can be larger to a securemonopolist than to a rivalrous firm that would face competition

from independent sellers of the old product. A monopolist incurs profit diversion from its old

good but may gain more than a rivalrous firm on the new good by coordinating the prices. In a

Hotelling framework, we find simple conditions for the monopolist’s gain to be larger. We also

explain why the ranking of innovation incentives differs under vertical product differentiation.

1. Introduction

Does initial market power dilute a firm’s incentive to invest in substitute new tech-

nologies in order to protect its existing profit? This question has longstanding interest

to policymakers and economists. In a seminal paper, Arrow (1962) showed that a se-

cure monopolist gains less from perfectly patentable process innovations—that lower

the marginal cost of an existing homogeneous product—than would a competitive firm

facing the same market demand. The logic is simple for a drastic innovation—one that

renders the old technology irrelevant. Postinnovation profit will then equal the lower-

cost monopoly level whatever the initial market structure, so the gain from innovation

is lower for an initial monopolist because only it enjoys status quo profit that the in-

novation cannibalizes or “replaces.” If the innovation is nondrastic (the new monopoly

price exceeds the old marginal cost), however, there is an opposing effect: a monopolist

that innovates will earn higher profit postinnovation than would an innovator that faces

competition from the old technology. Nevertheless, Arrow proved that a monopolist’s

gain is lower by using a different argument: the value of a process innovation comes

solely from reducing the firm’s marginal cost and this cost reduction applies to a smaller

output under monopoly than under homogeneous Bertrand competition (see also

Tiro le, 1988).

This output level argument, however, is specific to reductions in marginal cost

for a homogeneous product and leaves the open question: Does Arrow’s ranking of

We thank Axel Anderson, Tim Brennan, Malcom Coate, Jim Dana, Andrew Daughety, Jorge Fernandez, Ian

Gale, Richard Gilbert, Ed Green, David Malueg, Federico Mini, David Sappington, Daniel Vincent,Scott Wall-

sten, Greg Werden,Ralph Winter, anonymous referees, and the Editor for helpful discussions and comments.

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 3, Fall 2013, 513–528

514 Journal of Economics & Management Strategy

innovation incentives across market structures extend to nondrastic product innovations,

where the new good is a differentiatedsubstitute for the initial good and does not entirely

displace it? Our main finding is that the ranking can be reversed—the incentive to

undertake substitute product innovations can be stronger for a monopolist.1Compared

to a rivalrous firm, a monopolist adding a substitute product will divert profit from its

old product, but may gain more from the new product by coordinating the two prices.

We show that the coordination effect can dominate.

Specifically, our model compares a firm’s incentive to add a new product Bunder

three alternative market structures, where the firm’s gain is denoted in parentheses:

secure Monopoly (Gm)—a monopolist controls product Aand only that same firm can add

B;ex post Duopoly (Gd)—a monopolist controls product Abut only a different firm can

add B; and perfect Competition (Gc)—product Ais supplied by homogeneous Bertrand

rivals (Arrow’s case), and any firm can add B. One motivation for these comparisons

is that policy interventions can alter the market structure and, hence, the innovation

incentive, as under the following scenarios.

Merger Scenario: Suppose producers of good Aare competitive, only they have the

requisite assets to add product B, and they propose a merger-to-monopoly in A.The

gain from adding Bis Gmif the merger is approved and Gcif the merger is rejected.

Patent Scenario: Good Ais supplied by a monopolist protected by a patent that also

blocks innovation in B. If the patent is retained, the innovation incentive is Gm;ifitis

voided, market Abecomes competitive, and the innovation incentive changes to Gc.

Regulation Scenario: Suppose there is a durable franchise monopolist in Aand the

policy choice is between (i) granting that firm also the monopoly rights over a competing

future product B, versus (ii) barring that firm from B. Under regime (i), the incumbent

is unconcerned with preemption in B,soitsgainfromaddingBis given by Gm; under

regime (ii), only an entrant can innovate in B, and its gain is given by its profit under ex

post duopoly,Gd. Option (ii) may be motivated by a (correct) concern that the incumbent

would price the new product higher than would an entrant.

We represent product differentiation as horizontal, following the classic frame-

work of Hotelling (1929; see also Tirole, 1988), adapted to allow asymmetries: products

Aand Bcan differ in their “qualities”—their value to consumers gross of transport

costs—or (equivalently for modeling purposes) in their marginal costs. We show that

Gm>Gdif and only if the new product has higher quality than the old, and that

Gm>Gcalways holds. Thus, the incentive for product innovation can be greater under

secure monopoly than under market structures that admit product market rivalry.

In some such cases, overall welfare also is higher under monopoly. Of course, these

findings should not be construed as advocating monopoly since our analysis abstracts

from various potential inefficiencies of monopoly, such as internal slack (Raith, 2003;

Schmidt, 1997). The results merely caution against sweeping claims that monopoly

invariably undermines product innovation.

Our model purposely omits several important factors discussed in the literature

that can influence relative innovation incentives under alternative market structures,

such as imperfect patent protection, the stochastic natureof R&D outcomes, and scope for

follow-on innovations. (See, for example, Vickers, 2010; Gilbert, 2006; Reinganum,

1989;Tirole,1988.) We retain Arrow’s environment of perfect patent protection and a

1. We assume the new product is a substitute instead of a complement for the initial good because

the view that a monopolist resists innovation to protect its initial profit presumes substitute technologies.

(A complementary new technology would enhance rather than devalue the old one.)