Question

In a competitive market with identical firms, the inverse demand function is p = 100 – Q. The supply curve is horizontal at a price of 70, which implies that each firm has a marginal cost of 70. However, one firm believes that if it invests 1,000 in research and development, it can develop a new production process that will lower its marginal cost form 70 to 20, and that it will be able to obtain a patent for its invention. Would this profit-maximizing firm undertake the innovation (assuming that the market lasts one period?) Would consumers be better off or worse off if this firm could not obtain patent protection?

Answer 1

If the new firm acquires monopoly power through patents, we can expect it to use MR = MC rule for profit maximization. Here MR = 100 - 2Q and MC = 20 (after the innovation)

100 - 2Q = 20

Q = 80/2 = 40 units and price P = 100 - 40 = $60 per unit

Now profits are revenue - cost = 60*40 - 20*40 - 1000 (for research and development) = 600

Since profits are positive after the innovation, this profit-maximizing firm undertakes the innovation

Consumer surplus changes from CS = 0.5*(100 - 70)*30 = 450 to CS = 0.5*(100 - 60)*40 = 800.

Consumers will be worse off if this firm could not obtain patent protection because after the patent and reduction in marginal cost, their surplus has increased.