ChainWhat it assumes · how to break it
Start
A dominant firm, for example a large pharmaceutical company with patented medicines, faces little competition and earns supernormal profit.
1
As a result, the firm earns supernormal profit that barriers to entry protect in the long run.
supernormal profit · barriers to entry
supernormal profit · barriers to entry
Assumes: Barriers stop rivals competing the profit away.
But: If the market is contestable, entry or the threat of it squeezes profit, leaving less to fund research.
2
This means the firm has retained profit to finance research and development without relying on costly external borrowing.
retained profit · R&D
retained profit · R&D
Assumes: The profit is reinvested, not paid out to shareholders.
But: Shareholders may demand high dividends or share buybacks, so little of the profit goes into research.
3
Since patents and other barriers let the firm keep the rewards of a new product, it has an incentive to take the risk of investing in innovation.
patents · incentive to innovate
patents · incentive to innovate
Best link to attack
Assumes: The firm needs to innovate to protect its profit.
Assumes: The firm needs to innovate to protect its profit.
But: A secure monopoly may feel no threat, so it can earn high profits without the cost and risk of research.
4
Therefore, the firm develops new products and lower-cost processes, so the market becomes more dynamically efficient over time.
dynamic efficiency
dynamic efficiency
Assumes: R&D spending turns into useful innovations.
But: Research is risky and many projects fail, so high R&D spending does not guarantee new products.
End
Monopoly power can raise innovation and dynamic efficiency, because protected profit funds and rewards R&D.
Evaluation chain
- E1However, a monopoly innovates only if it faces some pressure to do so.
- E2If the firm's profits are safe because barriers are high and no rival threatens its position, then it can earn high profits without the cost and risk of research.
- E3As a result, it may delay new products or buy up small innovative rivals to protect its existing products.
- E4So monopoly power is likely to raise innovation where firms face a threat of entry or compete to win patents, and to reduce it where the monopoly is secure and complacent.
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Questions this answers
- Assess whether monopoly power encourages innovation.
- Explain how supernormal profit can lead to dynamic efficiency.
- Discuss whether competition or monopoly is more likely to promote innovation.
Diagram
Monopoly diagram with the supernormal profit rectangle as the source of R&D funds; show dynamic efficiency as the AC (and MC) curves shifting down over time as new processes are adopted.
Reverse and related
More competition → profits squeezed, leaving less to fund research, though the pressure to stay ahead of rivals may push firms to innovate.