The Schumpeter Hypothesis

1. The Schumpeter hypothesis links firms operating under a monopoly market structure as most important for technological innovation. Arrow, on the other hand, suggests most progress can be achieved in a perfectly competitive market.
Compare and contrast these two arguments.

An important issue in economics is how market structure affects innovation.

In 1934, Schumpeter observed that some markets become increasingly concentrated, both with respect to innovation activities and market competition. Based on this, he claimed that economic concentration will lead to a situation where innovation is predominantly performed by a few large entities. Later on he extended this notion to a normative understanding summarised in the so-called Schumpeter Hypothesis, which suggests that monopolists are more important engines of technological progress, because their size and market power enables them to profit more from successful innovation.

Schumpeter (1942) claimed that society must be willing to put up with imperfectly competitive markets in order to achieve rapid technical progress. He argued that large firms in imperfectly competitive markets are the most conducive conditions for technical progress. To the extent that firms in more concentrated industries operate in a way that more closely approximates imperfectly competitive markets in which firms possess market power, this led to the long-standing and much debated hypothesis that more concentrated industries are more conducive for innovation.

The Schumpeterian hypothesis challenged conventional economic thinking on the ideal market structure for optimal resource allocation and sparked a preponderance of both theoretical and empirical papers on the topic. Based on Shumpeter’s argument, policies that seek to limit or eliminate imperfect competition could simultaneously reduce the amount of innovation that a society enjoys. This argument states that market concentration, i.e. lack of competition, is beneficial to innovation activities. Based on Schumpeter’s (1934 – 1942) views on the necessity of high profit levels and large internal R&D resources it has argued that concentrated markets provide an innovative environment. Schumpeter argued that more monopolistic firms can more readily perform R&D activities because they face less market uncertainty and have larger and more stable funds. The first economist to identify flaws in the Schumpeterian analysis of innovation was
Kenneth J. Arrow who, in a seminal paper, questioned the common view that monopoly stimulates innovation (Arrow 1962).The counter-argument is based on the finding of Arrow and has been generalized as stating that competitive environment spurs innovation. According to this argument the monopolist has the possibility to slack and no need to innovate.
Arrow (1962) argues that current possession of market power should result in greater innovative activities as due to moral hazard problems, there may be a need to finance innovation internally, which puts firms with market power at an advantage since these firms may have supernormal profits.

For a monopolist, innovation simply replaces one profitable investment with another, something that Arrow called the “replacement effect”. Incumbents may thus be resistant to change or unable to respond to radical innovation due to organisational inactivity. The monopolist may actually receive a lower net return from introducing a new innovation that displaces activities of the old one. This is because the opportunity cost of innovation adds to the actual cost arising when the official’s capital stock is locked into a particular technology, slowing response to a new more profitable innovation. Arrow stated that when there is competition to innovate, monopolists innovate at a slower rate than competitive firms, who in turn innovate below the socially optimising level.

Arrow, like Schumpeter, was generally disposed to the view that the market system had intrinsic limitations in dealing with innovation, hence that incentives to invent might be inadequate from a social welfare standpoint, and that the amount of progress produced might be suboptimal. Arrow announced the conclusion that, if there was something that made monopoly superior to competition in terms of promoting innovation, it must have something to do with appropriability. In a sense, therefore, Arrow followed Schumpeter in suggesting the relevance of market structure to appropriability while not attempting to fully explicate such a relationship.

The overall effect of market structure on innovation is complex. Theory has generally supported Schumpeter’s hypotheses. The empirical evidence in favour of Schumpeterian innovation dynamics, on the other hand, is weak. Arrow stated that when there is competition to innovate, monopolists innovate at a slower rate than competitive firms, who in turn innovate below the socially optimising level. This has been confirmed empirically in a study of innovation in transition economies which concluded that new firms drive innovation and that for these firms competitive pressures raise innovation.