As Paul Romer elegantly summarised in his seminal article, ‘technological change arises in large part because of intentional actions taken by people who respond to market incentives’ (Romer, 1990, p.S72).
25 These improved biofuels are produced from lingo-cellulosic feedstock i.e. ‘low-cost crop and forest residues, wood process wastes, and the organic fraction of municipal solid wastes… with no additional land requirements or impact on food and fibre production’ (IEA, 2008). 26 The ‘synthesis’ refers to ‘synthesis gas’ from which synthetic diesel and aviation fuels can form via a thermo -chemical reaction.
An obvious way for a firm to produce new technologies is to invest in R&D. The amount of time, money and resources that a firm spends on R&D is a cost. In general, a firm would only decide to invest in R&D if the total future discounted profits were higher than the total costs. Under perfect competition and information, all new knowledge would eventually become available to other firms, which would compete in the market, driving price down to marginal cost. Hence firms would only make normal profits from sales and the firm that undertook the research would make a loss - it might as well not have bothered spending any resources on R&D.
However, R&D in the commercial sector does take place, which suggests that the reasoning above is too simple. Where do the incentives come from? First, firms would not invest in any R&D in a perfectly competitive environment. As we explained above, that would be absurd because the firm would almost certainly make a loss. A firm must be able to make a profit from the sales of the new good, and therefore will only invest in R&D if the market for this good is imperfect. For example, there may be few firms in the market so that even if the new technology is adopted by other firms, the innovating firm can make sufficient oligopoly profits. Alternatively, the firm may be certain that no one can copy its goods, either because the technology is too advanced or because it has been granted a patent. In that case the firm will make monopoly profits in the market (for the duration of the patent) and again will find it worthwhile to invest.
It is worth noting that both tough competition and monopoly can discourage innovation. A monopolist has no real incentive to innovate if it knows that the barriers to entry are too high and its dominating position is not under threat. Innovation will only occur in a market with some degree of competition - by a monopolist who feels a threat of a new entrant or by a smaller firm that wants to jump ahead of competition and gain market share (Aghion et al., 2005).
12.1.1 Knowledge from the outside
Once we consider any simple real world example, such as calculus or an internal combustion engine, it becomes obvious that innovation does not only come from within the firm. It is crucial to understand how firms are able to use external knowledge to produce new products. First, firms may maintain links with university departments or sponsor research institutes. Second, firms help finance new small ventures by buying equity stakes in them (Dushnitsky and Lenox, 2005). Third, firms may pool resources together to form an R&D cartel. They would exploit positive spillovers from their research to develop a technology, which they would be able to sell in an oligopolistic market (Kamien et al., 1992).
Whatever the pattern of research, a firm uses and builds on the existing stock of knowledge producing new technologies in order to lower costs. But this new technology will have a positive spillover on other firms: they will find it easier to carry out their own research and lower their costs (Bernstein and Nadiri, 1988). Having found out about an original idea, they may work towards building their own technology or they could wait until the patent expires and then use the technology for free. Eventually, almost any new knowledge will become available to anyone: ‘knowledge is inherently a public good’ (Jaffe, 1986, p.984).
Yet this pattern of knowledge production creates a fundamental problem. If firms are already engaging in research, there is an incentive for some firms to avoid investing, wait, and simply free-ride on the spillovers from the new research. For example, fuel cells may be an excellent alternative to the internal combustion engine in the future, but they require much more funding committed to their R&D to be a commercially viable product. But most firms are unwilling to commit to finance a particular development now because they do not want to be the ones bearing the costs should the technology not be profitable or not succeed at all. Because so many firms do not contribute, a particular technology today is underprovided and there is market failure. Viewed as a public goods game, we could say that the firms are stuck in Pareto-inefficient Nash equilibrium - we are locked into using the internal combustion engine. If all firms concerned coordinated and committed funds to the technology, they would all end up being better off. And if we consider the fact that the technology would dramatically reduce CO2 emissions, we,
as a society, would be better off from the coordination.