We turn now to the effects that innovation and technological change can have on individual markets and industries.

Innovation
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 them for years). See this BBC report on how the internet has transformed business.

Product innovation

Product innovation is a driving dynamic in most markets – be they markets for goods or services – consider for example how important innovation is perceived to be in these markets:

• Telecommunications
• Pharmaceuticals
• Transport
• Audio-visual products
• Knowledge industries

Differentiation of products:

Product innovation is often associated with many small-scale and subtle changes to the characteristics and performance of a particular product. Ground-breaking product innovation appears to becoming rarer despite for example the billions of dollars spent each year by the global pharmaceutical companies and household goods manufacturers.

New markets and “synergy demand”:

Product innovation creates new markets, especially when the emergence and exploitation of technology creates radically different products for consumers. Innovation is also a source of synergy demand. Gillette (a business unit of Proctor and Gamble) launched in 2004 the successor to its top branded product the Mach3 and Mach3 “turbo” razor. The new “wet-shave” razor is battery powered – handy given that Gillette also owns the Duracell battery brand! (Think back to the idea of cross-price elasticity of demand at AS level!).

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 shares of well-established businesses. Schumpeter famously made reference to innovation creating “gales of creative destruction”.

Examples of disruptive innovations:

• 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
• The expansion of the internet and e-commerce challenging the economics and the business models of existing bricks and mortar retailers who have limited shelf space.
• Consider the impact of online music download businesses such as iTunes and peer to peer file sharing. This is having a huge effect on the online and traditional music industry.
• Voice over Internet Protocol VoIP such as Skype versus traditional telephone and mobile phone service providers.

Gains in dynamic efficiency:

Dynamic efficiency occurs over time. It focuses on changes in the 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 in the long-term, 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 product and process innovation actually have the effect of reducing barriers to entry because they can strike right at the heart of the 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, in backroom administration, 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 have the effect of causing an outward shift in market supply and they also provide the scope for businesses to enjoy higher profit margins with a given level of demand. Process innovation should lead to a more efficient use of scarce resources reflected in gains in productive efficiency / productivity.

The diagram above uses standard cost and revenue curves to show the effect of driving down production costs from SRAC1 to SRAC2 – leading to lower prices and a higher level of output. You could also use this diagram to show the gains in producer and consumer surplus that come from cost-reducing innovation and technological change.

Consumers also stand to gain from such innovation in that they should be able to expect lower prices. This increases their real incomes, allows for a higher level of consumer surplus and means that there is less pressure for increases in wages in order to boost real living standards.