The experiments of Schumpeterian Tradeoff

The model we shall use to explore these issues has been described in Chapter 12 . As in that chapter, the focus here is upon the competitive struggle between firms with different R&D policies.

Again as in Chapter 12, we will explore the effects of initial in­ dustry concentration upon the survivability of the innovative firms. But in addition to initial variation in industry structure, we here ex­ plore the implications of different assumptions about the difficulty of innovation and imitation and about the aggressiveness of invest­ ment policies of large profitable firms for the viability of the inno­ vating firms.

This chapter is especially concerned with the Schumpeterian trade­ offs . The different social costs identified above are all reflected in the model. The fact that imitation is costly and usually takes time means that the use of the best technology is limited. This will show up in a gap between best practice and average practice. Also, when there are many firms in the industry, more innovative R&D (and more R&D successes) may be required to keep the industry as a whole on a given productivity track than would be the case if access to the best technology were free to alL As indicated above, invest­ ment restraint on the part of firms who perceive that they have market power may also be ref lected in the model. The consequences, as in textbook theory, are a wider gap between price and average cost, a lower level of output, and a higher price than would be the case if firms did not exert market power.

We will examine the benefits of a higher level of R&D spending and a higher rate of innovation in both science- based and cumula­ tive technology cases. There are three parameters in the model that can be interpreted as abstract counterparts of policy variables. They relate to the ease with which technologies can be imitated, the extent to which large firms exert investment restraint, and the initial size distribution .

We undertook three sets of simulation experiments. In each exper­ iment, half of the firms do innovative R&D as well as imitative R&D, while the other half do imitative R&D only. Imitative R&D spending per unit capital is constant across all firms; similarly, spending on in­ novative R&D per unit capital is the same in all the fi rms that spend at a positive level. In each case we have established initial conditions in which all firms are the same size and in which the industry is approximately in equilibrium at the prevailing productivity level. We  have  also  ruled  out  entry.  These  assumptions  give  us  a clear innovator- imitator struggle and a definite reference point for the de­ gree of concentration that exists in the industry at any stage of the process.

The n umbers used to calibrate the model were chosen so that four simulation “periods” correspond to one calendar year. Under this in­ terpretation, the average annual sales-capital ratio in the industry is in rough accord with that in technologically progressive industries . The rate of growth of latent productivity is roughly 2 percent per year in our slow- growth condition and 6 percent per year in the fast­ growth condition. The ratio of innovative R&D spending to sales is 6 percent-a more realistic value than was used in the preliminary study reported in Chapter 12. In the difficult- imitation setting, a given probability of imitating best practice required twice as much imitative R&D as in the easy- imitation setting. We ran the simula­ tion for 101 periods, or twenty-five years after initial conditions.

Within this framework, the three sets of experiments described below correspond to more specific contexts. In each set we explored the behavior of the system under different settings of particular parameter values.

1. Behavior and Performance in a Science-Based Oligopoly

Our first set of experiments was concerned with the behavior of an industry in which concentration is initially high and in which the in­ vestment policies imputed to firms produce a regime of relatively restrained competition. The industry involved is science-based, in that latent productivity evolves over time at a rate determined by outside forces. All firms start out with productivity levels close to then-prevailing latent productivity. Of the four firms in the industry, two spend resources on R&D, aiming to keep up with the moving frontier of possibilities. The other two do not spend resources for this purpose, but aim to imitate the R&D leaders (the R&D leaders also look to technologies used by other firms) .

In the context of this science-based oligopoly, we wanted to ex­ plore the effect on behavior and performance of two variables: rate of growth of latent productivity and ease of imitation. To what extent does the evolution of the industry-in p articular, the relative success of the firms that do innovative R&D and of those that aim to imitate-depend on the pace at which new R&D targets evolve over time? How does the ease with which one firm can imitate the tech­ nology of another influence the evolution? The runs here are, we think, interesting in their own right. They also are interesting as a base of comparison for simula tion experiments in which initially the industry is less concentrated. Understanding the results of the four-firm runs greatly facilitates one’s ability to see through the workings of the model more generally and thus to interpret what is going on in other contexts.

Our past experience with running our model industry, starting it out with a quite concentrated structure, led us to make several pre­ dictions.3 First, latent productivity will be tracked relatively well by the innovative firms because their level of innovative R&D spending, given the other parameters of the model, is s ufficiently high so that each samples the evolving distribution of new technological possi­ bilities relatively frequently. Second, the imitating firms will track the innovating firms relatively closely because their level of imitative R&D expenditure is s ufficiently high that, even in the difficult­ imitation setting, it is unlikely that many periods go by without their being able to imitate the best technology in practice. Third, under some circumstances firms that do not bear the costs of innovative R&D may tend to be slightly more profitable than the firms that do, but the innovative firms will nevertheless survive, make money, and even grow relative to the imitators . The investment restraint shown by the large firms in this context limits the extent to which a firm more profitable than its competitors exploits that advantage by trying significantly to increase its market share. In this atmosphere of restrained competition, firms that are not maximally profitable are sheltered. And even if they have a run of bad luck their capacities for recuperation are not quickly eroded.

Regarding the social merit of the industry behavior considered in these runs, certain predictions are relatively obvio us. One is that the industry will be characterized by high markups over production cost; thus, there will be significant “triangle losses.” A second is that, compared with a more competitive industry, there will be less waste due to the use of inferior technologies (there will be less of a gap between average and best practice). Third, R&D spending will be more efficient in the sense that less total R&D outlay is req uired to keep average practice moving at a given distance from potential best practice. Whether price will be higher or lower is an open question.

2. A More Competitive Science-Based Industry

In the second simulation experiment we started the industry initially with sixteen equal-sized fi rms, eight of these doing both innovative and imitative R&D and eight doing only imitative R&D. As in the four-firm case, in some of our runs latent productivity advanced at a rapid rate and in others latent productivity grew more slowly; we set imitation as easy in half of our runs and “hard” in the other half. One important difference between the range of experimental variation in the sixteen-firm runs and the four-firm runs is this: in some of the sixteen-firm runs we preserved the assumption, contained in the four-firm runs, that a firm’s desired net investment rate falls as its market share increases; in other words, we explored what would happen if a firm, as its market share grew in relation to that of its competitors, continued to expand rapidly even if it had only a mod­ erate gap between price and cost. We did not experiment with this variant in the four-firm case both because we wanted to employ that case as a benchmark interpretable as restrained oligopoly and’ be­ cause the experiments of Chapter 13 suggest a tendency for relative shares to be relatively well preserved in the four-firm case even if in­ vestment behavior is not restrained. In the sixteen-firm case, in con­ trast, it seemed worthwhile to experiment with this variant for two reasons. First, because the focus here is on the effect of a more com­ petitive structure than is presumed under the four-firm case and be­ cause the extent to which firms as they grow large exploit their advantage or hold back seems to be an important dimension of com­ petitive behavior. Second, as suggested earlier, a central question to be explored is the extent to which a certain degree of restraint in pushing one’s advantage is a requirement if firms that do innovative R&D are not to be destroyed by those that pursue the strategy of a “fast second .”

There are several things that can be predicted with some confi­dence about the industry performance in the sixteen-firm case as contrasted with the four-firm case. Above we discussed the expected differences in average price-cost margins, the gap between average practice and best practice, and R&D efficiency for regimes with the same rate of growth of latent productivity. Another expected dif­ ference between the four-firm and sixteen-firm runs is that in the latter the initial industry structure will not prove to be stable. In gen­ eral, concentration can be expected to increase under the force of Schumpeterian competition. There is one particular competitive struggle that we will want to watch attentively and to consider as a function of the various parameter settings: the performance and sur­ vival of the firms that do innovative R&D, compared with those that do imitative R&D. A s traightforward conjecture is that the ability of innovative firms to prosper and survive depends positively on the rate of latent productivity growth (which determines the average advance achieved through innovative R&D) and negatively on the ease of imitation.

3. A Competitive In dustry with a Cumulative Technology

In this third set of simulation experiments we preserved the basic as­ sumptions of the second set, with the following exceptions. Instead of assuming that innovative R&D yielded random draws on a moving distribution of technological possibilities, we assumed that innovative R&D involved the incremental improvement of pre­ vailing techniques . The probability distribution of innovative R&D successes for a firm was centered on its existing technique. Thus, the firms doing innovative R&D incrementally grope their way upward through the set of technological possibilities .

The alternative assumptions about the rate of growth of latent pro­ ductivity that w ere built into the earlier two experiments were re­ placed in this experiment by the following. Under one assumption the distribution of innovative R&D finds is packed close around the prevailing technique and a major advance in productivity is un­ likely. Under the alternative assumption the distribution is more spread out, and the firm has a greater chance of coming up with a significant increase in productivity from a single innovation.

We varied the parameter settings regarding ease or difficulty of i mitation in the same way in these runs as in the science-based case. We also explored the difference that it would make .if firms as they grew large did or d id not exert investment restraint.

The most important contrast between this set of runs and the ear­ l ier set of sixteen-firm runs is that in the earlier cases there is an ex­ ogenous force pushing forward the frontiers of knowledge. If only a little innovative R&D is done in the i nd us try, the average success from that effort will be a relatively spectacular advance, reflecting the movement forward of latent productivity since the prior R&D suc­ cess. In the present experimental context there is no such outside force. If innovative R&D in the i ndustry is squeezed down by the d ynamics of Schumpeterian competition, the rate of progress of best practice and average practice can be predicted to decline also.

Source: Nelson Richard R., Winter Sidney G. (1985), An Evolutionary Theory of Economic Change, Belknap Press: An Imprint of Harvard University Press.

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