Question

How could a firm which operates in a monopolistic enviroment use its economic profits to fund research and development to prevent new entrants in the long run?

Answer 1

DEFINITION OF MONOPOLISTIC ENVIRONMENT

Under this Environment there is large number of firms that produces differentiated products which are close substitute of each other . It is the type of market in which large seller are selling the product that are similar , but not compete with each other on other factor besides price.

RESEARCH AND DEVELOPMENT LEADS TO INNOVATION

Research and Development (R&D) is an activity met in many modern organizations and especially those that operate in high-tech sectors. Its aim is to produce technological change and innovation. Technological change and innovation refer to the development and introduction of new products, services, materials, production methods, supply sources, technical procedures and organizational forms. R&D offers competitive advantages to successful innovators and improves social welfare. On the social level, new technology has a positive impact on the efficient use of available resources, on economic growth and living standards, while on the industry level it has an impact on production,
product quality, employment, wages and profits. Consequently, the extent to which industries develop new ideas and promote new products and services, affects not only private firms, but society as a whole. Innovation, however, like
all other economic activities, is not free of charge. It absorbs economic resources in the form of R&D expenditures. R&D expenditures are the money spent on creative work, undertaken on a regular basis, in order to increase the stock
of knowledge used to devise new or to improve existing applications. R&D expenditures take the form of investments in building laboratories, occupying specialized personnel, experimenting and establishing cooperation networks with organizations, universities, research centers, private firms and individuals. R&D is a process that involves many different stages. Among economists there is a disagreement about the title and the number of stages.

The oldest and most well-known classification is that of Schumpeter to invention, innovation and diffusion. Modern economists, such as George et al and Lipzcynski & Wilson, have suggested a more detailed classification. They separate R&D in basic research (evolution of ideas and inventive activity for scientific reasons), applied research (research aiming to determine commercialization potential of a new application), development (organizing production facilities), commercial production and innovation (full-scale production, promotionand distribution) and diffusion (spread of the new idea to the market). Nevertheless it would be wrong to interpret these stages as stages of a linear process. Each stage is characterized by different parameters, the results of which affect the
parameters of the other stages. For example, inventions improve drastically after they are put into widespread use.

USES OF FUND FOR RESEARCH AND DEVELOPMENT TO PREVENT NEW ENTRANCT IN LONG RUN

The evaluation of the impact that R&D has on new firm entry, will be carrier out by outlining the arguments have been put forward for and against its role as an entry barrier.

Schumpeter Written : "for there are advantages which, though not strictly unattainable on the competitive level of enterprise, are as a matter of fact secured only on the monopoly level". The main reasons, that according to Schumpeter , justify the superiority of the large monopolistic firm over small competitors, are the availability of financial resources and the security offered by the large market share against the risk of failure. Some other causes can be found in Galbraith (1956), and have to do with the ability to share the risk of failure by taking on multiple projects, the ability to achieve economies of scale in R&D and the ability to use distribution and marketing advantages in order to penetrate markets more and accelerate R&D returns on investment. Other arguments in favor of the large firm were mentioned by Yamey (1972), and relate with its ability to secure superior factors of production for research and its ability to take advantage of a safe competitive environment in order to focus on R&D projects.

Consequently, according to the Schumpeterian hypothesis, small and medium size scale entry are destined to fail, since small and medium-sized companies will never be able to survive in the long term. The only chance of successful entry and seize of market share could come either from new firms that invest heavily in R&D, or from large firms that diversify from other sectors. Examples of empirical studies
that support the Schumpeterian hypothesis are those of Freeman (1974) and Alexander et al. (1995).

USES OF FINANCIAL RESOURCE IN OVER ALL MARKET

The main reasons, that according to Schumpeter (1942), justify the superiority of the large monopolistic firm over small competitors, are the availability of financial resources and the security offered by the large market share against the risk of failure. Some other causes can be found in Galbraith (1956), and have to do with the ability to share the risk of failure by taking on multiple projects, the ability to achieve economies of scale in R&D and the ability to use distribution and marketing advantages in order to penetrate markets more and accelerate R&D returns
on investment. Other arguments in favor of the large firm were mentioned by Yamey (1972) [15], and relate with its ability to secure superior factors of production for research and its ability to take advantage of a safe competitive
environment in order to focus on R&D projects. Consequently, according to the Schumpeterian hypothesis, small and medium size scale entry are destined to fail, since small and medium-sized companies will never be able to survive in the long term.

The only chance of successful entry and size of market share could come either from new firms that invest heavily in R&D, or from large firms that diversify from other sectors. Examples of empirical studies that support the Schumpeterian hypothesis are those of Freeman (1974) and Alexander et al. (1995).

SO THE FUNDAMENTAL BARIER IS CAPITAL MARKET

Nevertheless, the arguments that R&D affects entry do not stop here. As mentioned earlier, the most fundamental barrier to R&D are capital requirements. Incumbent firms may use a part of their profits in order to fund their research activities. New firms on the other hand, should, in most cases, turn to the capital market. While turning to the capital market, the new firm will face a number of disadvantages: difficulty in securing loans, as new firms cannot prove their ability to repay them and difficulty in convincing financial institutions to fund R&D projects, as R&D projects involve a high risk of failure and most of these investments constitute sunk costs. Other problems arise from the high interest rates and the long repayment period needed, in most cases, in order to diffuse an innovation and start gaining economic returns from it. All the above affect entry levels and entry modes. A first case is that entry will not occur, since a new firm will not succeed in obtaining the necessary finance. The other case is that entry will take place, but with many disadvantages for the incoming firm. Examples of these disadvantages are the limited amount of funds, the inability to employ highly qualified personnel, the lack of equipment, lack of facilities, lack of communication infrastructure etc. Another case is that the new firm will take on a short R&D project, satisfying thus the desire of investors to avoid high risk and earn fast economic returns. The last case is that R&D will be carried out by using solely own funds, but this can be done from a limited number of firms.

Another advantage of incumbent firms relates with economies of scale in R&D (Galbraith, 1956; Comanor, 1967; Scherer, 1991). Economies of scale in R&D are mainly due to reduced costs and increased profitability resulting from better use of expertise staff, laboratories, distribution and promotion networks. Economies of scope in R&D also play an important role. As pointed out by Galbraith (1967), the uncertain nature of R&D means that a larger portfolio of research programs has a safer return than a smaller one. The reason is that technological progress that takes place in one project can also be used in different projects. A small new firm, on the other hand, faces high risk, as it must concentrate all its efforts in developing a single innovative idea, the success or failure of which will determine its survival.