Can Profits Prevent Innovation?

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Original Xerox 914 copymachine; Source Wikimedia

There are many different types of factors that impact innovation rates (Choices in pursuing innovation). There are cases when high levels of profits can prevent companies from investing in innovation. But the question is why would this happen. Shouldn’t a company innovate to continue making profits? Shouldn’t they be innovating to stay ahead of competition?

There are times when this isn’t the case. This condition is the result of a monopoly or an extremely small number of serious competitors. A prime example of this type of behavior was Xerox. In the late 1950s, Xerox created the first copy machine. For the next 20 years the firm held the only patent on copying technology. This allowed the company to extract monopoly rents. What does monopoly rents mean though? Looking at the picture below we can see the pricing differences the Pm dotted line indicates the price point that is best for the monopoly holder. The Pc solid line is the line that a competitive market would price the same good. In some ways this is some what theoretical, however it’s also practical. The graph also shows that the Pc is the same as the marginal cost. Which typical economic theory argues that most products should be priced.

Because of this difference between Pc and Pm there’s actually a wide gap in demand that is not met. Putting this back into terms of Xerox, Xerox could set the price at some higher level than the marginal cost, meaning they will make a huge profit on the product. As they have no pressures from competitors, they have no need to actually innovate to reduce the cost of the product.

Pricing for a good based on monopoly or a competitive market

In more competitive markets or even within the photocopy business after the Xerox patent expired, an innovation within the competitive market can drop the cost of production for a company. During that time they will be able to do one of two things, drop prices to increase market share or keep their pricing the same and try to increase profits, in most cases companies go for the lower pricing. It increases the size of the market in general as it moves the price down on the demand curve. In the graph above, the DWL (Deadweight loss) is the size of the unserved demand based on the pricing at the monopoly level. This sort of logic works for incremental innovation and radical innovation from the perspective of the monopoly. As soon as a legal monopoly ends there will likely be both incremental and radical innovations.

This article has been slightly more technical than some of my previous articles. However, I think it’s important to understand how this process works. It is because of the negative impact on consumers, in terms of higher prices and pricing consumers out of products that could improve their quality of life (or keep them alive), that governments decide to step in to prevent monopolies from being formed or breaking up monopolies.

Just this week, the AT&T merger with T-Mobile US basically ended because the FCC felt that the merger would be bad for consumers. It would reduce the need for innovation as it is difficult to move from one wireless provider to another without huge costs. Both AT&T and T-Mobile use GSM while Verizon and Sprint both use CDMA, so a user would have to purchase a new phone in addition to changing networks if service is subpar. In addition, the FCC argued that it would slow the roll out of 4G because there’s less competition between Verizon Wireless and AT&T, another good size network will increase the competition and innovation in all of the networks.

Another classic example is the case of Microsoft (MS). Microsoft has been hit in many courts for abusing its monopoly, however Microsoft does something really smart with their operating system to increase the market size. Microsoft has different pricing levels based on the consumer. Students and users from developing countries are able to purchase Windows and other products at a lower cost to build a user base.

Through MS products we can see other examples of innovation stagnation. Many versions of MS Office and Windows did not include many new innovations. It has not been until Apple‘s recent resurgence that MS has seriously pushed out new innovative products in Windows 7 and Office 2007. These products are very different than their predecessors. In this case it was not an actual competitor, it is the threat of a competitor that is driving the innovation.

In closing, earning monopoly level profits can prevent companies from investing in innovation. This can be countered through government action or in environments where there is little patent protection (or historically had) such as the software industry. This allows copy cats to quickly move into a market even with established players. In the case of Xerox they had little incentive to innovate until their patent expired and new competitors can move in.

In my next article I’ll discuss different types of intellectual property protection and some of their impact on innovation. Follow Ryan on twitter @kapsar.