In which markets and under which circumstances will firms innovate most? We'll focus on these and related questions, in the next couple of videos. So, on the one hand, firms in competitive markets could be said to have strong incentives to innovate. Because after all they're not making huge profits from their existing operations anyway, and they have every incentive to innovate and differentiate themselves from their competitors. But on the other hand, firms that have a strong competitive position in their industry, will claim and will find that their dominant or even monopolistic position is under threat. And that they innovate, because they simply have to. Let's now look at these aspects from a more structure perspective, and we'll start out by looking at a competitive market. So let's start with a simple set up. The simple set up is that we've got 100 consumers interested in motorbikes. 60 of those consumers would pay a maximum of 5,000 Euros. 40 consumers would pay a maximum of 400 Euros, and with the current technology we have total production costs of 300 Euros. There is now a new process innovation out there, and that process innovation would decrease my production costs from 300 to 200 euros. The simple idea is that whoever spends most on the innovation will get the innovation. Either by being granted a patent or by being first in the market, right? So that's a simple idea, very simple setup. Now in a competitive market we assume that there are 10 companies producing and selling motorcycles. Prior to the innovation, everyone of them has the same production technology. So without innovation, of course, the total production costs are 300 Euros. Every company sets a price that's equal to the cost, which means that, of course, each company makes zero profits, right? Because after all, if prices are equal to marginal costs, then you're going to have no profit margin, and therefore you're going to make zero profits. What happens with innovation? And again, assume that one firm can protect the innovation here. We now have total production costs of 200 Euros for the company that gets the innovation. We get 300 Euros for all the other firms, which means that the company that has the innovation, the company that came up with the process innovation, can now set a price of 299 Euros. Remember, we're selling exactly the same motorcycle. Which means that all consumers are going to buy from this company, because it has a lower price. So therefore, the overall profits of this company are, 100 consumers, because we sell both to the high willingness to pay and the low willingness to pay consumers, at a price of 299, which gives us a profit margin of 299 minus 200. So therefore, it's going to be 100 times 99 or 9,900. So the profits of the company, the profits of the innovator, are going to be 9,900. All the other companies do not sell anything and they make zero profits. So with that simple calculation we can calculate, we can figure out, what the value of an innovation is for a firm that is currently in a competitive market. So the total value of an innovation is simply by comparing the profits with innovation, with the profits without innovation. So the profits with innovation, we know, are 9,900. Profits without innovation are 0. And so, therefore, the difference and the value of innovation is simply, 9,900 minus 0, right? So that's going to take us to 9,900. That is the value of innovation. That is how much each firm is going to be willing to pay the get the patent that reduces the production cost from 300 to 200 Euros. So given that we've now looked at the competitive market, let's now have a look in the next video at what the monopolistic market is going to tell us. Thanks very much, and I'll see you in a second.
