Innovation and Invention in Markets | tutor2u Economics
Study notes

Innovation and Invention in Markets

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB

The Oxford English Dictionary defines innovation as “making changes to something established"

Innovation and invention

The Oxford English Dictionary defines innovation as “making changes to something established"

Invention is the act of “coming upon or finding: discovery"

Often associated with small, subtle changes to the characteristics and performance of a product

New markets and “synergy demand":

  • Innovation creates synergy demand e.g. new smart phones increase demand for apps

Sustaining and disruptive innovations

  • Many new products are similar to existing ones – these are “sustaining innovations"

Examples of disruptive innovations:

  • Online streaming services, such as Spotify, Deezer and MixRadio – digital streamed music digital now accounts for 50% of UK music industry revenues
  • The Uber app is a challenge to the market power of established taxi companies
  • Air BNB challenges dominant hotel chains in many cities around the world

Innovation and dynamic efficiency

Dynamic efficiency 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

Innovation can be a barrier to entry in markets

Property rights embedded in product innovations might be protected by patent laws

Joseph Schumpeter

Austrian economist Joseph Schumpeter stated that innovation is the primary cause of economic progress and development. Innovation is a process of 'creative destruction' in which old ways of doing things are repeatedly destroyed and replaced by new, better ways. This forces existing businesses and industries to adapt to new conditions by innovating to keep up or resisting change and risking being made obsolete.

There can be a first mover advantage" for successful innovators that gives them scope to exploit some monopoly power in a market.

  • But high rates of innovation reduce barriers to entry
  • Technology may free businesses from a single source of supply – e.g. Open Source software
  • Technology may not necessarily be a source of competitive advantage – if competitors exploit it too

Process innovation

  • Process innovations involve changes to how 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 - impact on prices and profits and consumer welfare

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.

The diagram below uses cost and revenue curves to show the effect of driving down production costs from SRAC1 to SRAC2 – leading to lower prices and a higher 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 stand to gain from such innovation in that they should be able to expect lower prices. This increases their real incomes.

Analysis of cost reducing innovations

Technology Mechanism

How It Creates an Business Advantage


A new process

Produce faster, at lower cost or better quality

Internet banking

Solve a complex problem

Do something competitors find hard to master

Google search engine

A new product

The first product to market

The iPod

Protect a valuable idea

Have something others can only sell if they pay for a licence

Pfizer's Viagra

Rewrite the rules

A completely new approach which makes other products and markets redundant

Digital cameras

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