Innovation & Management in the Energy Industry

Lecture 3 Innovation

Basics of innovation Innovation management Innovation in duopoly External effects and patents Patent races Innovation in the energy sector

Basics of Innovation

Definition

Dimensions

Basics of InnovationDefinition (I)

Innovation: Creation of something new which is of value

New to a firm New to a market / customer group New to the world

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Basics of InnovationDefinition (II)

Schumpeterian trilogy Invention = creation of a new idea or technology discovery

Innovation = successfully developed inventions commercialization

Diffusion = spread of a new innovation throughout society

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Basics of InnovationDifferent Perspectives

Business administration Innovation to gain a competitive advantage Innovation process and structure in a company Commercializing inventionsMicroeconomics Innovation in competition External effects of innovation Monopoly through patentsMacroeconomics Innovation and growth

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Basics of InnovationExample: Solow Model

Solow-growth model (1956) Production depends on

technology, capital and labor. Innovation = an increase in the

level of technology With technology growth the

equilibrium output of each worker increases as well.

Innovation is the fundament for growth.

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Source: Greenhalgh, C. and Rogers, M. (2010) Innovation, Intellectual Property and Economic Growth. Princeton University Press.

Basics of Innovation

Definition

Dimensions

Basics of InnovationForms of Commercial Innovation

Product innovation Creation of a new product, significant change in an existing product E.g. computers, smart phones

Process innovation Introduction of a new process for production E.g. assembly lines, fast food

Other forms of innovation Marketing innovation: E.g. Facebook profile for companies Organizational innovation: E.g. new accounting procedure

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Basics of InnovationMicroeconomic Benefits

Product innovation Increased willingness-to-pay through better products Stealing of market share from competitors Creation of new markets

Process Innovation Reduction of fixed or variable cost Lower prices than competitors

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Basics of InnovationIncremental vs. Radical Innovation

Incremental Innovation Improvements of an existing

product or process E.g. improving computer

hardware

Radical Innovation Very different from existing

solutions, old technology becomes obsolete

E.g. Internet

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Source: Pun, K. & Gill, R. (2001) Integrating EI/TQM efforts for performance improvement: a model. Integrated Manufacturing System, 13 (7), 447-458.

Innovation Management

Need for Innovation

Innovation Process

Customer Adoption

Innovation ManagementDrivers for Innovation

Financial pressure (cost reduction, efficiency) Market changes Increased competition Structural change Availability of new technology New regulation Cultural changes (e.g. energy transition)

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Innovation ManagementRoles for Companies

Different roles: Pioneer, Follower, Laggard

First-mover advantages Technological leadership which can be used for new products Switching costs for customers Preemption of scarce assets (first-come, first served)

First-movers disadvantages Cost of R&D Free-rider effect of other companies (imitation) Bears full risk of market uncertainty

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Innovation Management

Need for Innovation

Innovation Process

Customer Adoption

Innovation ManagementSources of Innovation

Technology push R&D department of a company provides a new technology. The technology is commercialized by the company and creates its

own demand. E.g. iPhone

Market pull Market research discovers a new customer need. The company develops a new product to cater to this need. E.g. hybrid cars

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Research and Creativity Invention

Design & Development Innovation

Market Research Market Need

Design & Development Innovation

Innovation ManagementTechnology Push vs. Market Pull

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Technology push Market pullSource Research and Development MarketActivity Exploratory research Market researchProcess Probe-and-learn Stage-gateMarket application Unknown KnownMarket uncertainty High LowTechnological uncertainty High LowTime span Long-term Short-term

Innovation ManagementProcess of Innovation (Technology Push)

17Source: Greenhalgh, C. and Rogers, M. (2010) Innovation, Intellectual Property and Economic Growth. Princeton University Press.

Innovation ManagementInnovation funnel: Closed vs. Open Innovation

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Open innovation: Inclusion of a wide range of internal and external innovation sources Reduction of boundaries between a firm and its environment Customer innovation, cooperation, academic institutions etc.

Source: Karlheinz Kautz, (2009) "Guest editorial", Information Technology & People, Vol. 22 Iss: 4

Innovation Management

Need for Innovation

Innovation Process

Customer Adoption

Innovation ManagementCustomer Adoption

20Source: Rogers, E. M. (2003). Diffusion of innovations. New York: Free Press.

Innovators: willing to take risks, close contact to scientific sources Early Adopters: fastest adopters, trendsetters Early Majority: slower adoption process Late Majority: skeptic about innovations, lower financial status Laggards: aversion to change

Distribution of market share

Innovation ManagementNetwork Effect (Positive Externality)

Network Effect: Utility which a user receives from the good is dependent on its utility for other people. The more people use this product or service the more valuable it becomes to the group.Examples

Facebook is increasingly useful for an individual person if more people are active users.

Watching a well-known movie has additional utility as it can be discussed with other people.

A critical mass is needed for some innovations to be usefulCustomers can be locked-in using a specific innovationWinner-takes-all markets for innovative companies

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Innovation ManagementLock-in Effect: QWERTY

Almost all keyboards use the same layout. It is not necessarily the most efficient or practical way to write

on a computer. However, switching to another system is accompanied by huge

costs. Reasons for this historical lock-in (David 1985):

a) Technical interrelatedness: e.g. complementarity between hardware and software

b) Demand side economies of scale: e.g. keyboard buyers want that most people can write on it

c) Irreversibility of investments: e.g. costs of retraining typistsd) Randomness of choice: i.e. other system would work as well

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Innovation in Duopoly

Introduction

Bertrand-Competition

Cournot-Competition

DuopolyStrategic Interaction

Competitive markets offer a passive environment (e.g. companies are price takers).

In contrast, oligopoly markets include strategic interaction between participants.

Strategic interaction o A firm considers the decision of his competitors when deciding on its own action.

Bertrand Model (1883): Firms set prices and the quantity adjusts according to the market demand.

Cournot Model (1838): Firms set quantities and prices adjust to sell the quantities (e.g. an airline who chooses to supply a number of flights and has flexible pricing according to the daily demand).

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Innovation in Duopoly

Introduction

Bertrand-Competition

Cournot-Competition

Bertrand-CompetitionAssumption

Two firms (i, j) produce identical goods at the same marginal cost c. The price is the strategic variable of the firms. Customers choose the lowest price. If both firms charge the same

price, both companies serve half of the market:

, =

< 12 = 0 >

Profit function of firm i: , = (,

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Bertrand-CompetitionSolution

Both firms charge the competitive price: = j =

Firms price at marginal costs and do not make profits.Two firms are already enough to attain the competitive equilibrium

solution (Bertrand-Paradox)!Argument (Nash equilibrium) If > > : Firm i has no demand. It would be better off by

charging = . If = > : Firm is profit is

12(). By lowering its price

a bit it could get the profit ( )which is larger for small .

If > = : Firm j could increase its price slightly and would still serve the whole demand and increase profits.

The only situation where no one wants to deviate is = j = . 27

We are assuming here that firms are not colluding/coordinating

Bertrand-CompetitionInnovation and Cost Reduction

Process innovation leads to lower costs for firm i, i.e. < .

The innovation is non-drastic such that > .

The Nash equilibrium is = and = (firm i charges an below to serve the whole market).

The innovator collects all efficiency gains and makes a profit of ()().

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Shubham Bansal

Innovation in Duopoly

Introduction

Bertrand-Competition

Cournot-Competition

Cournot-CompetitionAssumptions

Firms choose their quantity instead of prices. Profit:

, = +

Assuming linear demand and costs: = 1 , = + = 1

= , < 1 Firm i maximizes its profit:

, = 1

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Cournot-CompetitionSolution

First-order condition of profit maximization:1 2 = 0

Reaction function of firm i considering the quantity of j:

=1

2

Symmetric Cournot equilibrium yields:

= 13

and = 1+23>

Both companies charge a price above marginal costs.

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Cournot-CompetitionInnovation and Cost Reduction

Process innovation leads to lower marginal costs for firm i, i.e. =12+

3

The innovating firm profits from an increase in the market share.

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Shubham Bansal

External Effects and Patents

External Effects

Patents as Solution

External Effects and PatentsLack of Innovation Incentive

Research efforts are very costly and success is uncertain. Companies must be able to commercialize their innovation to cover

costs. But: new products and processes can often be easily copied by

competitors.

Innovation has a positive external effectPatents are a regulatory remedy

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External Effects and PatentsExample: Imitation

Chinese imitation of an IKEA store

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http://www.dailymail.co.uk/news/article-2021607/First-fake-Apple-stores-China-fake-Ikea-shop-Kunming.html

External Effects and Patents

External Effects

Patents as Solution

External Effects and PatentsProtecting Innovation

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Method Share of companies that view it as important

Patents 13%Trademarks 19%Copyrights 18%Confidentiality agreements 28%Lead-time advantage 30%Complexity of design 24%Secrecy 28%

Strategic protection of innovation is important!

Source: Swan, P. G. M. (2009). The Economics of Innovation. Edward Elgar Publishing

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Shubham Bansal

External Effects and PatentsPatents (I)

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Disclosure of the invention to the public Possibility of licensing or trade Patent holder can sue infringer Length of term: usually 20 years Renewal not possible

Distinction Copyrights: rights to artistic, dramatic and musical works Trademarks: rights to words, symbols and other marks

External Effects and PatentsPatents (II)

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Positive effects Companies have an incentive to invest in research as they are the

only one who can sell their innovation. The design of the innovation is made public and can be used as a

basis for further innovations.

Negative effects The innovating company is a monopoly and sets higher prices than

under competition. Access to the innovation is more limited. E.g. controversy of medical drug patents

Shubham Bansal

Shubham Bansal

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External Effects and PatentsReminder: Monopoly Outcome

()

A = transformed from consumer surplus to producer surplus

C = loss in producer surplus

B = loss in consumer surplusA B

C

net effect = decrease of total welfare by B + C compared to perfect competition

Demand

Marginal Revenue

Monopolist is able to make a profitInefficient equilibrium: Output is too low.

Patent Races

Introduction

Model

Results

Patent RacesBackground

Schumpeters (1943) thesis: If one wants to induce firms to undertake R&D, then one must accept the creation of monopolies as a necessary evil!

Intuition Public good character of innovation: any innovation by one firm

provides usable information to other firms at little or no cost. While all firms would like to use such information, no firm is

willing to bear the (often huge) necessary costs to produce it without compensation.

A patent compensates the innovating firm with a temporary monopoly!

Dilemma: A patent system encourages R&D and thus innovation but prevents the diffusion of innovation and creates non-competitive market structures!

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Shubham Bansal

Patent RacesGeneral Idea

It is attractive for a firm to appropriate a patent and the subsequent monopoly rent.

Since a firm wants to be first to receive the patent, R&D competitionbetween firms ensues.

Each firm has an incentive to accelerate its research program at thecost of incurring additional expenses.

o The firms are thus said to race for a patent.

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Patent Races

Introduction

Model

Results

Patent RacesAssumptions

Two firms: monopolist and entrant. The monopolist produces at marginal cost . Process innovation lowers marginal cost to . The two firms compete in R&D activities: the first firm to innovate

obtains and exploits a patent. Patents have an infinite duration.

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Patent RacesProfits

Monopolists profit before the innovation: (). If monopolist innovates, then the monopoly persists with

monopolist profit > and entrant profit 0. If entrant innovates, then a duopoly obtains:

monopolist profit , and entrant profit , . Efficiency effect assumption: , + , . In a homogenous good industry a monopolist does not make less

profit than two non-colluding duopolists. If he wished, the monopolist could always duplicate the situation

of the non-colluding duopolists.

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Patent RacesUncertainty of Innovation

Firm i is assumed to spend the amount between time t and t + dt.

Its probability of making a discovery during this interval is modelledby , where h is a concave, increasing function and h(0) is very large.

A firms probability of making a discovery at time t depends only on the flow of its expenditures at that time and not on past expenses (memoryless innovation).

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Shubham Bansal

Patent RacesR&D strategies

R&D competition between two firms is characterized by tworesearch-expenditure intensities specified as functions of time 1()and 2() up to the moment when one of the two firms obtains the patent.

At each date t if neither firm has made a discovery the game starting at that moment is identical to the initial game.

Therefore, the equilibrium R&D strategies 1() and 2()will be independent of time.

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Patent RacesThe Race

The R&D process is assumed to start at time t = 0 and to be of thePoisson type with the following implied probability that at time t no firm has made a discovery:

1 +(2)

If there has been no innovation before t, then the monopolist realizes a profit of 1 between t and t + dt.

Probability of the monopolist winning the race at time t: 1

Discounted stream of profits over time from t onwards: ()

Probability of the monopolist losing the race at time t: 2

Discounted stream of profits over time from t onwards: (,) 49

Patent Races

Introduction

Model

Results

Patent RacesPresent Discounted Payoffs

Let denote the present discounted value of the expected profit over time for each firm i Monopolist

1 1, 2

= 0

1 +(2) 1 + (1)()

+ (2)(, )

= 1 + (1)

() + (2)

(, )

+ (1) + (2)

Entrant2 1, 2

= 0

1 +(2) 2 ,

2 =

2 ,

2 + (1) + (2)

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If the monopolistic profit is more than duopoly proft then the monopolist would innovate to maintain his monopoly position

Patent RacesWhich Firm Will Win the Race?

The firm spending more on R&D will win the race. Two decisive effects: Efficiency effect suggests that the monopolist will spend more on

R&D: , ,

Replacement effect suggests that the entrant will spend more on R&D: The marginal productivity of R&D expenditure decreases for

the monopolist with his initial profit ( )

11< 0.

Intuition: the monopolist foregoes a flow profit whendiscovering early and replacing himself.

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Patent RacesInterpretation

Tendency towards entry: In case of a drastic innovation the implied cost savings are

substiantial. The efficiency effect thus vanishes and the replacement effect

dominates.

Tendency towards monopolistic persistence: If the probability of discovery per unit of time is high, then

innovation is achieved early. The danger of losing the race to the entrant is more imminent to

the monopolist than his own replacement. The replacement effect thus diminishes and the efficiency effects

dominates. 53

Innovation in the Energy Sector

Innovation in the Energy SectorCharacteristics

Innovation is a necessity to satisfy growing energy needs. It can take some 40 years to develop an innovation. Failure rates need to be lower than in other sectors. Economies of scale, capital intensity and complexity of products.

Innovation in energy can drive changes in other sectors. Heavy influence of regulation on innovation efforts, e.g. subsidies

for renewable energies.

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Innovation in the Energy SectorDrivers

Energy trilemma Energy security Universal access to affordable energy services Environmentally sensitive production and use

Innovation is criticalPartnership between public and private sector

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Innovation in the Energy SectorDimensions

Technological Innovation: Electricity generation / transmission/ storage

Political Innovation: Energy policy Commercial Innovation: Pricing Regulatory Innovation: Incentive based regulation

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Lecture 3Summary

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There are various kinds of commercial innovation Product innovation Process innovation

Incentives for innovation depend on the market situation and theregulatory environment (patents,)

Related to energy, four types of innovation complement each other: Political innovation Regulatory innovation Commercial innovation Technological innovation