Staff Report 402

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Monopoly and the Incentive to Innovate When Adoption Involves Switchover Disruptions

Thomas J. Holmes - Consultant
David K. Levine - Visiting Scholar
James A. Schmitz, Jr. - Senior Research Economist

Revised December 23, 2008

Abstract
Arrow (1962) argued that since a monopoly restricts output relative to a competitive industry, it would be less willing to pay a fixed cost to adopt a new technology. Arrow’s idea has been challenged and critiques have shown that under different assumptions, increases in competition lead to less innovation. We develop a new theory of why a monopolistic industry innovates less than a competitive industry. The key is that firms often face major problems in integrating new technologies. In some cases, upon adoption of technology, firms must temporarily reduce output. We call such problems switchover disruptions. If firms face switchover disruptions, then a cost of adoption is the forgone rents on the sales of lost or delayed production, and these opportunity costs are larger the higher the price on those lost units. In particular, with greater monopoly power, the greater the forgone rents. This idea has significant consequences since if we add switchover disruptions to standard models, then the critiques of Arrow lose their force: competition again leads to greater adoption. In addition, we show that our model helps explain the accumulating evidence that competition leads to greater adoption (whereas the standard models cannot).


Published In: American Economic Journal: Microeconomics (Vol. 4, No. 3, August 2012, pp. 1-33)

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