Technological advance is a three-step process that shifts the economy‘s production possibilities curve outward enabling more production of goods and services.
1. Invention: is the discovery of a product or process and the proof that it will work.
2. Innovation: is the first successful commercial introduction of a new product, the first use of a new method, or the creation of a new form of business enterprise.
3. Diffusion: is the spread of innovation through imitation or copying.
Expenditures on research and development (R&D) include direct efforts by business toward invention, innovation, and diffusion. Government also engages in R&D, particularly for national defense. Finding the optimal amount of R&D is an application of basic economics: marginal benefit and marginal cost analysis. Optimal R&D expenditures occur when the interest rate cost of funds is equal to the expected rate of return.
Many projects may be affordable but not worthwhile because the marginal benefit is less than marginal cost. Often the R&D spending decision is complex because the estimation of future benefits is highly uncertain while costs are immediate and more clear-cut.
The Role of Market Structure:
1. Pure competition: the small size of competitive firms and the fact hat they earn zero economic profit in the long run leads to serious questions as to whether such producers can finance substantial R&D programs. The firms in this market structure would spend no significant amount. However, firms of the same industry may gather their resources and develop R&D programs.
2. Monopolistic competition: there is a strong profit incentive to engage in product development in this market structure as the firms depend on product differentiation to stand out from a large number of rivals. However, most firms remain small which limits their ability to secure inexpensive financing for R&D and any economic profits are usually temporary. Therefore, spending on R&D is limited in this market structure.
3. Oligopoly: many of the characteristics of oligopoly are conducive to technical advances including: their large size, ongoing economic profits, the existence of barriers to entry and a large volume of sales. Firms in oligopoly spent the highest amount on R&D among the four different market structures.
4. Pure monopoly: monopoly has little incentive to engage in R&D as the profit is protected by absolute barriers to entry, the only reason for R&D would be defensive – to reduce the risk of a new product or process which would destroy the monopoly.