The Market as a Selection Environment

The perception that market competition in a s ector constitutes a par­ ticular sort of selection environment was explicit in the writings of many of the great nineteenth- and early twentieth-century economic theorists. Schumpeter was well within this classical tradition. In a stylized Schumpeterian evolutionary system, there is both a carrot and a stick to motivate firms to introduce better production methods or products. ilBetter” here has an unambiguous meaning: lower cost of production, or a new product that consumers are willing to buy at a price above cost. In either case the criterion boils down to a higher monetary profit. Successful innovation leads to both higher profit fo r the innovator and to profitable investment opportuni ties . Thus, profitable firms grow. In so doing they cut away the market for the noninnovators and reduce their profitability, which, in turn, will force these firms to contract . Both the visible profits of the innovators and the losses experienced by the l aggers stimulate the latter to try to imitate.

The Schumpeterian dynamics differ somewhat depending on whether the innovation is of a new product or a new process. For product innovation, the profitability to the firm depends s trongly on the uncertain reactions of potential consumers. For process innova­ tion, which does not change the nature of the product, the market constraints are far more blunt. The firm can make an assessment of profitability by considering the effects on costs, with far less concern for consumer reaction. Further, and reinforcing these differences , product innovation usually comes from a firm’s own R&D; signifi­ cant process innovations often come from the R&D done by suppliers and are embodied in their products. To the extent this is so, imita­ tion by a competitor of a process innovation is likely to occur rela­ tively rapidly and to be encouraged by a marketing supplier, rather than retarded by a patent.

Both expansi on of the innovator and imitation by competitors are essential to the viability of the Schumpeterian process . In the stand­ ard descriptions of dynamic competition, expansion of the innovator is likely to be stressed. It is surprising, therefore, that the relation­ ship between innovation and investment has hardly been studied empirically at all. The principal studies of firm investment have been based on neoclassical theory modified by Keynesian considerations and tend to ignore the relationship between innovation and expan­ sion of a firm. The Meyer-Kuh (1957) retained earnings – capacity pressure theory would imply that successful innovators tend to ex­ pand. Presumably a successful innovation both yields profits and at­ tracts demand, which may, initially at least, exceed capacity. A more s traitlaced neoclassical theory also would predict that firms that come up with better processes and products ought to want to expand their capacity to produce. But the major studies of firm investment have, virtually without exception, ignored the influence of innovation on investment.

The exceptions are studies in which the author’s basic hypothesis is oriented to ward the Schumpeterian in teractions. Mueller (1967) does find that lagged R&D expenditure by a firm has a positive influ­ ence on its investment in new plant and equipment. In a later study, Grabowski and Mueller (1972) used lagged patents as a measure of R&D output, but find that the influence on plant and equipment in­ vestment  is  weak  statistically.  Mansfield’s  studies  (1968)  give s tronger support for a Schumpeterian view. In examining invest­ ment at an industry level, Mansfield found that the number of re­ cent innovations is a significant explanatory variable, augmenting more traditional variables. But p erhaps his most interesting results involve comparisons of firm growth rates, where he found that inno­ vating firms in fact tend to grow more rapidly than the laggers. How­ ever, although the advantage of the innovators may persist for sev­ eral periods, the advantage tends to damp out with time, apparently because other firms have been able to imitate or to come up with comparable or superior innovations.

In contrast to the spareness of studies of the relationship of invest­ment to successful innovation, a large number of studies have fo­ cused on the spread of innovation by diffusion (imitation) in profit-oriented sectors. These have ranged across a variety of sectors, including agriculture (study of the diffusion of hybrid corn among farmers), railroads (diesel engines), brewing, and steel. Many have documented the role of profitability of an innovation in influencing the speed at which that innovation spreads. However, other studies have concluded that the calculations made by firms tend to be hap­ hazard and that even ex post the firms had little idea, quantitatively, how profitable the innovation turned out to be (Nasbeth and Ray, 1974). Several have found that, for innovations that are costly to put into operation, large firms (with greater fi nancial resources) tend to adopt a new technology earlier than do smaller firm s, although there are exceptions. Most of the studies show an S-shaped pattern of use of the new innovation over time. In many cases this has been attrib­ uted to the fact that the later users are observing the behavior (and perhaps the performance) of the earlier adopters before making their own decisions. In some instances the innovations were inputs pro­ vided by a supplier, and the early adopters of the i nnovation were not in a position to block subsequent use of their competitors. In other instances this was not the case. For example, a glass-producing company, Pilkington, holds the basic patents on the float glass process and presumably had an interest in limiting diffusion to o ther firms except where Pilkington was blocked from the market. It is interesting that the analysts of diffusion h ave not in general been cognizant of these differences .

It also is quite surpri sing that in no study of which we are aware has there been an attempt to examine together the dual roles of ex­ pansion of the innov ator and imitation of the imitator. It would seem that in order for a market selection environment to work effectively, a rather fine balance is required between the two mechanisms. We will return to this issue later.

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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