A2 Micro: Innovation Efficiency and Welfare

The Oxford English Dictionary defines innovation as “making changes to something established”. Invention, by contrast, is the act of “coming upon or finding: discovery”. Innovations frequently disrupt the way that businesses do things and may have been doing so for years. Many well-established businesses have come under pressure from innovative challenger brands and products.

Product innovation is a driving dynamic in most markets – consider for example how important innovation is in these markets:
o Telecommunications
o Pharmaceuticals
o Transport
o Audio-visual products
o Green energy and transport
o Farming (important at this time given the global food crisis)

Product innovation is often associated with small, subtle changes to the characteristics and performance of a product.

New markets and “synergy demand”:

Product innovation creates new markets, especially when new technology creates radically different products for consumers. Innovation is also a source of synergy demand. For example, the British ‘challenger-brand’ King of Shaves launched a new razor (the Azor) in 2008 and its success has generated extra demand for its range of shaving oils and gels.

Sustaining and disruptive innovations

Many new products are similar to existing ones on the market – companies are often satisfied with “sustaining innovations” rather than “disruptive innovations” which have the power to upset the status quo and make serious inroads into the market share of well-established businesses. Joseph Schumpeter famously made reference to innovation creating “gales of creative destruction”.

Examples of disruptive innovations:
o Emergence of the low-cost airlines following a radically different business model – this has had a huge effect on national scheduled airline carriers such as British Airways.
o Consider online music download businesses such as iTunes and Spotify
o Voice over Internet Protocol VoIP such as Skype versus traditional telephone and mobile phone service providers.

Innovation and dynamic efficiency

Dynamic efficiency occurs over time. It focuses on changes in consumer choice available in a market together with the quality/performance of goods and services that we buy. Innovation can stimulate improvements in dynamic efficiency, always providing that the innovations that come to market are appropriate in satisfying our changing needs and wants.

Innovation as a barrier to entry

Innovative behaviour can be an important barrier to entry in markets. Firstly because some the property rights embedded in product innovations might be protected by patent laws. There is nearly always a “first mover advantage” for successful innovators that gives them scope to exploit some monopoly power in a market. Set against this argument is that view that high rates of innovation reduce barriers to entry because they challenge existing market power enjoyed by well-established businesses.

Process innovation

Process innovations involve changes to the way in which production takes place, be it on the factory floor, business logistics or innovative behaviour in managing employees in the workplace. The effects can be both on a firm’s cost structure (i.e. the ratio of fixed to variable costs) as well as the balance of factor inputs used in production (i.e. labour and capital).

Cost reducing innovations cause an outward shift in market supply and they provide the scope for businesses to enjoy higher profit margins with a given level of demand. Process innovation should also lead to a more efficient use of resources