Monopoly power can be good for innovation, according to new research by Professor Federico Etro, published in the April Economic Journal. Despite the fact that the market leadership of firms like Microsoft is often criticised, their investments in research and development (R&D) can be beneficial to society because they expand the technological frontier and open new ways to prosperity.
Many technological innovations are developed by firms with patents on the leading edge technologies. These firms perpetuate their leadership and their market power through innovations. Etro”s research explains why the innovating process is naturally connected with the persistence of monopolies and why this apparently negative outcome can actually be positive for consumers and the society.
Since an old contribution by the Nobel Laureate Kenneth Arrow, economists have tended to believe that firms with leading technologies in theory have lower incentives to invest in R&D compared with outsiders. Etro”s research shows that this Arrow paradox disappears under two conditions: if 1) the current patent-holder acts as a strategic leader in the patent race for the new technology; and 2) the market is characterised by free entry, then the leader will actually have more incentives than any other firm to invest in R&D.
The reason is that by committing to a high investment in R&D, the leader will increase the probability of perpetuating its technological leadership without affecting the expected life of the current patent. The leadership of the current monopolist increases total investment in R&D and speeds up the process of technological innovation with positive consequences for consumer welfare and national growth. Paradoxically, a market with some persistence of monopoly is competitive, while one with continuous leapfrogging must hide some barriers to entry!
This outcome applies a more general result obtained by Federico Etro in a related research paper, ”Stackelberg Competition with Endogenous Entry”. In this study, Etro shows that in any market where entry is free but a firm has leadership, that firm will be more aggressive than any rival: produce more, set lower prices, choose higher quality products and also invest more in R&D. Moreover this leadership creates higher welfare for consumers. Paradoxically, Etro shows that in some cases leaders end up being so aggressive that other firms will not even enter the market: markets dominated by a single firm can actually be very competitive and efficient.
The implications for anti-trust law are clearly dramatic since, under reasonable conditions, this new theory of market structure shows that apparent monopolies are the natural outcome of free competition and limitations of their leadership may be deleterious.
”Innovation by Leaders” by Federico Etro is published in the April 2004 issue of the Economic Journal. Professor Etro is an economic consultant and affiliated with the UCSC, University of Milan, Italy.
