So in the previous two videos, we've looked at a firm coming out of competitive situation and a monopolist with no threat of entry. In this one we're going to combine it to some extent and we'll look at a monopolist but a potential entrant as well. So there's a threat of entry meaning that if the monopolist doesn't innovate then the entrant will. We'll take exactly the same set up, 100 consumers, 60 high willingness to pay, 40 low willingness to pay, a current technology of 300 euros per motorbike and a new technology of 200 euros per motorbike. Right? The only difference now is in the competitive setting, so we can compare what the incentives to innovate or the value of innovation is to each of those firms. We currently are looking at a monopolist. This monopolist is the only firm producing and selling motorbikes and that firm you can think it has a patent on the old production technology. So it's the only firm that can produce at 300 euros per bike. The potential entrant is interested in innovating because you know that or he knows that he can produce at 300 euros so if anything he could only get the innovation and produce at 200 euros. So, with innovation let's first have a quick look at an individual quiz to make sure that you're still with me. I hope that was fairly easy for you, so let's just repeat. The entrant staying out of the market means that there are production costs now of 200 euros for the monopolist. The entrant plays no role here in this setting. The monopolist again faces a choice of setting a price of 500 euros and making profits of 18,000 or setting a price of 400 euros and making profits of 20,000. So therefore, the best outcome is going to be to set a price of 400 euros and making profits of 20,000. Things get a bit more tricky if we look at the case without innovation. So if the monopolist does not innovate what's going to happen? The entrant is going to jump into the market. So, the entrant entering the market could mean that the monopolist and the entrant agree on a price of 400 euros. The market then is shared equally because they both produce the same motor cycle. It's just that the entrant can produce it at 200 euros a piece and the monopolist or former monopolist can produce it at 300 a piece. So they share the market equally and sell to 50 consumers each and there's going to be production costs of 300 euros for the monopolist who's stuck with the old technology and of 200 euros for the entrant. He more or less leapfrogged the current monopolist. We could of course now, figure out what the profits are first for the monopolist and then for the entrant. The monopolist sells to 50 consumers. He sells at a price of 400 euros and he has production costs of 300. That means that it's going to be 50 times 100. That's his profit margin, so overall profits are going to be 5,000 euros. Profits for the entrant again are going to be 50 because the entrant also sells to half of the market. The price is the same, so it's again 400 but production costs are 200. This means that he's going to sell to 50 consumers and have a profit margin of 200, so overall profits are going to be 10,000 for the entrant. From that we can derive what the value of innovation is. First for the monopolist simply by comparing the profits with innovation and the profits without. With innovation we know that the profits are going to be 20,000. Without innovation, the entrant is going to jump into the market and the monopolist is going to be left with a profit of 5,000. So if we then take the difference between those two, that's 20,000 minus 5,000 leaves the monopolist with a value of innovation or 15,000. So how do things look for the entrant? And we're comparing the profits with innovation and the profits without. With innovation, of course our profits are going to be 10,000 as we just calculated. Without innovation our profits are going to be zero, so the difference between the two is the value of innovation for the firm who wants to enter a market that's currently occupied by a monopolist. The interesting bit now is that we can compare the two different scenarios. Monopolist with the entry and a monopolist without the threat of entry and of course we can also include the competitive market. So the value of innovation in a competitive market is 9,900 euros. The value of innovation for a monopolist who is not threatened by an entrant is 8,000. Once he gets threatened by entry, his incentives to innovate shoot up to 15,000 and for the entrant it's 10,000. Just looking at these numbers we can see what we call the efficiency effect. The efficiency effect suggests that, under the threat of entry a monopolist has higher incentives to innovate than a potential entrant in the market. So 15,000 is more than 10,000. Why? Because he's interested in trying to predict his monopoly position. This of course goes against what we saw previously where the firm coming out of a competitive market had a higher incentive to innovate than the monopolist. What is the trade-off that a monopolist is facing? He's facing a trade-off between the replacement effect and the efficiency effect. The replacement effect suggests that there is less innovation by a monopolist because he's replacing old profits with new ones. The efficiency effect suggests that there is more innovation by the monopolist because he's concerned about protecting his own monopoly position. And of course you might ask, "Well, when is one more realistic, when is one more strong, when is one more relevant than the other? When does replacement effect bite and when does the efficiency effect bite?". Well, as we saw the main difference or the only difference between the second and third model we looked at was the threat of entry. Right? So the probability of entry determines if the replacement effect or the efficiency effect is more relevant. We can generally say that the higher the probability of entry, the more the efficiency effect is going to come into play and the lower the probability of entry, the more the replacement effect is going to bite. Now, under the last three videos, in the last three videos we asked, under which circumstances firms would innovate the most. We started out looking at a competitive market and we compared it to a monopolistic situation in the second video. We figured that a monopolist has fewer incentives to innovate than a firm coming out of a competitive situation and we asked, "Why?" Well, the reason was that by innovating the monopolist cannibalizes his own profits from the old technology. This is what we call the replacement defect, replacing old profits with new ones. In the last module we looked at, we imagined that the monopolist fears the threat of an entrant and being replaced as a monopolist. So there is now a potential innovation that would make it easy for a firm to actually enter the market. Under these circumstances, the monopolist will put in lots of effort and lots of money into this innovation. This is not necessarily because he can increase profits with the innovation itself. The idea is that the monopolist can now keep the entrant out of his own market by innovating and hence securing his monopoly profits. This is what we then called the efficiency effect. Combining all this suggests that a monopolist may be more innovative in some situations and in particular in situations where the threat of entry is particularly high. Or to put it differently, if we wanted to maximize the innovation efforts of firms there needs to be some degree of monopoly power to give firms a carat of innovating but at the same time there has to be a sufficient threat of entry which would work as a stick. In the next couple of videos we'll move on to another set of strategic aspects of innovation. For now though, stay tuned and I'll see you very soon.
