Creative destruction revisited

Among innovation economists Joseph Schumpeter is revered for his concept of 'creative destruction.' Still, he might not have been getting enough credit.

A while back, The Economist published a piece on innovation by monopolists. Traditionally, monopoly (or market dominance) is considered to discourage firms from innovating or doing anything else that might be in consumers' interests. Paradoxically, there is evidence that some of the firms with the largest market shares have above-average rates of innovation, as measured by R&D investments.

Why does it happen? A new paper by Federico Etro, of the University of Milan, aims to resolve Mr Arrow's paradox. He sets out a model in which a market leader has a greater incentive than any other firm to keep innovating and thus stay on top. Blessed with scale and market knowledge, it is better placed than potential rivals to commit itself to financing innovations. Oddly — paradoxically, if you like — in fighting to maintain its monopoly it acts more competitively than firms in markets in which there is no obviously dominant player.

Of course, this doesn't mean that all monopolies are wrongfully accused of abusing their market power. For one, Etro's findings only hold under certain conditions:

The most important requirement for this result is a lack of barriers to entry: these might include, for example, big capital outlays to fund the building of new laboratories, or regulatory or licensing restrictions that make it hard for new firms to threaten an incumbent. If there are no such barriers, a monopolist will have an excellent reason to innovate before any potential competitor comes up with the next new thing. It stands to lose its current, bloated profits if it does not; it stands to gain plenty from continued market dominance if it does.

If the world works in the way Mr Etro supposes, the fact that a dominant firm remains on top might actually be strong evidence of vigorous competition. However, observers (including antitrust authorities) may well find it difficult to work out whether a durable monopoly is the product of brilliant innovation or the deliberate strangulation of competitors. More confusing still, any half-awake monopolist will engage in some of the former in order to help bring about plenty of the latter. The very ease of entry, and the aggressiveness of the competitive environment, are what spur monopolists to innovate so fiercely.

But what if there are barriers to entry? These tend to make the dominant firm less aggressive in investing in new technologies—in essence, because its monopoly with the existing technology is less likely to be challenged. Over time, however, other companies can innovate and gradually overcome the barriers—“leapfrogging”, as Mr Etro calls it. Meanwhile, the monopolist lives on marked time, burning off the fat of its past innovations.

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