Economic growth and economic development 563

Introduction to Modern Economic Growth 12.3.3 Innovation and Ex Post Monopoly Let us now return to the same environment as above, and suppose that if firm undertakes a successful innovation it can obtain a fully-enforced patent Once this happens, firm will have better technology than the rest of the firms, and will possess ex post monopoly power This monopoly power will enable the firm to earn profits from the innovation, potentially encouraging its research activity in the first place This is the basis of the claim by Schumpeter, Arrow, Romer and others that there is an intimate link between ex post monopoly power and innovation Let us now analyze this situation in a little more detail It is useful to separate two cases: (1) Drastic innovation: a drastic innovation corresponds to a sufficiently high value of λ such that firm becomes an effective monopolist after the innovation To determine which values of λ will lead to a situation of this sort, let us first suppose that firm does indeed act like a monopolist This implies that it will choose its price to maximize ¡ ¢ π I1 = D (p) p − λ−1 ψ The first-order condition of this maximization is ¡ ¢ D0 (p) p − λ−1 ψ + D (p) = Clearly the solution to this equation gives the standard monopoly pricing formula (see Exercise 12.1): (12.2) pM ≡ λ−1 ψ − εD (p)−1 We say that the innovation is drastic if pM ≤ ψ In this case, firm can set its unconstrained monopoly price, pM , and capture the entire market (2) Limit pricing: when the innovation is not drastic, so that pM > ψ, the equilibrium will involve limit pricing, where firm sets the price p1 = ψ, so as to make sure that it still captures the entire market (since in this case if it were to set p1 = pM , other firms can profitably undercut firm 1) This type of limit pricing arises in many situations In the case we have just 549