the effect of technical change on market structure

THE EFFECT OF TECHNICAL CHANGE ON MARKET STRUCTURE

MICHAEL GORT* and RICHARD A. WALL* *

The paper examines the effects of technical change on market structure. It is found that: 1 ) the role of independent inventors and small firms is much more important in the early stages of the evolution of a product; 2) the net effect of innovations on entry reverses itself over the product cycle; 3) there is a shift in the importance of various sources of innovation over the product cycle. The two forces which contribute to this result are: 1 ) a decline in the importance of innovations as technology matures and 2) the proliferation of products adapted to specialized uses.

A glance across the spectrum of societies with their vastly differing rates of technical change, leads to an obvious question. Can differences in the rates of innovation among them be explained by the way in which their markets are organized? It is not surprising, therefore, that a large volume of literature arose [See Kamien and Sch- wartz (1982)], on the impact of market structure on innovation. Far less attention has been paid to the reverse effect of technical change on the structure of markets, the subject of this paper.

It is the view of the authors that as the technology of the industry of a new product evolves, systematic changes occur which modify, in predictable ways, the structure of markets. The objective of the authors is to specify both these changes and their effects. Though this paper does not focus on evaluations of policy, it will be shown that the effects of technology on market structure do have subtle but important policy implications.

The literature on the impact of technology on market structure has, thus far, centered on economies of scale and on the consequences of changes in technology for shifts in the minimum efficient size of plant or firm. A secondary theme has been the role of research and development effort as a barrier to entry.

The studies of Mueller and Tilton (1969), Tilton (1971), Pavitt and Wald (1971), and Gort and Klepper (1982) are especially relevant to the authors’ analysis. Mueller and Tilton, relying on data for semiconductors and photocopying, concluded that an upward shift occurred in the minimum efficient size of firm as the industry matured. After the initial stage of development when there were no clear economies of scale, technological competition began to contribute to entry barriers with technology favoring research and development done by large industrial research laboratories. When full maturity was achieved, entry barriers appeared to be based not on research and development requirements but on scale economies in production and marketing. Tilton’s study concluded that as product technology matures and its rate of change declines, producers shift to more capital-intensive production methods and the minimum efficient size of firms rises.

The conclusions of Pavitt and Wald are similar. They found the opportunities for small firms to be greatest in the early stage of an industry’s cycle, with entry heavily dependent on scientific and technological capability. As technologies mature, scale

*State University of New York at Buffalo. * *Canisius College.

Economic Inquiry Vol. XXII, October 1984

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GORT AND WALL: TECHNICAL CHANGE AND MARKET STRUCTURE 669

economies in production become more important. More recently, Gort and Klepper found that the impact of innovations on entry reverses itself in the course of the industry’s cycle. In the early stages, innovations create opportunities for entry. In contrast, in the later stages of the cycle, the sources of innovations change with the latter serving increasingly as an entry barrier.

Before proceeding further, it is necessary to consider the principal sources of innovations in products and production processes. After a new product has been launched commercially, what is the source of subsequent improvements in the product and in the way it is produced? It is useful to identify four broad sources of innovation: 1) independent inventors and university-based scientists and engineers; 2) producers of products largely unrelated to the innovation; 3) producers of the product which the innovation improves, or for which the innovation alters the process of production (These may be grouped with innovators drawn from the suppliers of equipment or of components for such producers.); 4) innovations resulting from planned and separately budgeted research and development effort. The critical distinction between categories 2 and 3 above is that for category 3, unlike 2, the innovation is likely to result from experience in production. The distinction between 3 and 4 is that category 3 innovation takes the form of informal development and learning by doing as contrasted with specialized research and development effort.

It is the authors’ conclusion that over the life cycle of a new product, innovation increasingly shifts from type 1 and type 2 sources to type 3 and type 4 sources. Types 1 and 2 have a large role in the early stages of an industry and contribute substantially to new entry. Types 3 and 4 increase in relative importance as the industry matures with organized research from within the producing industry, namely type 4, increasingly contributing to barriers to entry. A fifth source of innovation consists of devel- opments in other countries which are first introduced domestically either by a new entrant into the market or by a firm already producing the product. Based on the product cycle histories for forty-six products,l this source also appears to be more important in the early stages of a product’s development and has often been accompanied by new entry into a market. However, this conclusion may be peculiar to the experience of U.S. industries and in the period examined for the forty-six products, ending in 1973.

There are systematic forces which explain changes in the relative importance of qources of innovation 1-4 above, and they shall be examined shortly. A few examples of the process, however, may be instructive to place it in perspective. Consider the development of television receivers. The first television sets sold to the public, and improvements in cathode-ray picture tubes that made these sets possible, were introduced by an electrical engineer, Allen B. Dumont, through a small company. The large industry that already was producing radio sets and other communications equipment became dominant only later in production of television sets, even though RCA was among the early developers of television.

Early research on crystal piezoelectricity and initial commercial application were undertaken by university scientists. The first commercial seller of crystal piezo’s in the United States was a company formed by scientists Hunt and Gagne in 1936. Not until the 1940’s and 1950’s did the established communications industry take the lead in developing the product for countless applications such as radio equipment for

1. The forty-six products were those examined in the study of Gort and Klepper (1982).

670 ECONOMIC INQUIRY

military uses, phonograph crystals, ultrasonic cleaners, and x-ray equipment, The production of the zipper was initiated in 1894 by a self-educated engineer,

Whitcomb L. Judson, who for the next twelve years was responsible for substantially all improvements in the product. The Universal Fastener Co., begun by Judson and two partners and later reorganized and renamed the Hookless Fastener Co., remained the sole producers of zippers in the United States until 1926. In that year, three other companies were able to enter the market because of the development of the “helical spring” fastener. Work on this new fastener was largely motivated by the demand from overshoe producers to offer boots competitive with those of Goodrich, which had been using the Hookless Fastener Co.’s zipper. Again, the established industry became an important source of further innovation well after the introduction of the initial innovation.

The early innovations and commercial sale of outboard motors were not the work of established engine manufacturers but of a small company started by Bess and Ole Evinrude. The ball point pen was produced commercially for several years (in Argentina) by its inventor before the established fountain pen industry took over its development.

To be sure, counter-examples can be cited. The development of electric blankets and of home freezers were, from the beginning, largely the result of efforts by principal electric product manufacturers. However, neither was the product of a large research and development undertaking. Electric blankets were initially developed as a minor product intended for the specialized uses of tubercular patients. Home freezers were initially a simple adaptation of the ice cream dispenser.

A very different pattern of development may be observed for penicillin, lasers, and guided missiles. The commercial introduction of these products was, from the start, dominated by major manufacturing firms and accompanied by large research and development expenditures in research laboratories. These three cases, however, are in an important sense atypical. In each case, the government was either the principal or the exclusive initial source of demand. The government also was a dominant source of financing of research and development of lasers and guided missiles.

Moreover, early participation in a market by leading producers does not appear to restrict later entry by other firms, many of which are small. Consider the five products just discussed, as having been characterized by early innovations by established firms and early entry by producers important in adjacent markets. Four of these five (all except electric blankets) were characterized by a higher than median annual rate of entry in the period in which net entry was positive - that is, the period from the time of competitors’ entry, to the time the number of sellers in the market reached its peak. For guided missiles, the average annual rate of entry was one of the highest for any product, even though the early entrants and innovators consisted of leading firms in the aircraft engine and airframe industries. The identity of early entrants is not decisive in determining when entry recedes; rather it is the rate at which technology matures in the new industry.

The examples cited above generally reinforce inferences which can be drawn from the studies by Mueller and Tilton, Tilton, Pavitt and Wald, and Gort and Klepper. These inferences are: 1) the role of independent inventors, small firms, and new entrants into a market, are much more important in the early stages of the technological evolution of a product; 2) innovations are frequently accompanied by entry in the early stages. (In the late stages, on the other hand, the net effect of innovations on entry tends to be negative rather than positive.); 3) large-scale, orga-

GORT AND WALL: TECHNICAL CHANGE AND MARKET STRUCTURE 67 1

nized, industrial research and development as contrasted both with informal development that accompanies production, and research by individual scientists and inventors, tends to be an attribute of mature market structures - mature in the sense that the number of producers in the market is either near its historical peak or has already passed the peak.

The relative role of technology versus initial attributes of the structure of a new market in affecting subsequent entry is further reflected in table 1. The table shows, for a sample of forty-six products, the duration of the interval in the market’s evolution during which net entry remained positive. It also shows the average annual rate of entry for each product in this interval. Variations in both variables are large across the forty-six products. The interval of positive net entry averaged roughly ten years but varied from two years for artificial Christmas trees to twenty-five years for zippers. The average annual rate of net entry was roughly sixty times higher for television apparatus and parts than for electrocardiographs.

From a conventional view of entry barriers - that is, entry barriers depend on patents, product differentiation, large capital requirements, regulatory barriers, etc. - industries usually are classified on the basis of long-run differences in barriers, since most structural attributes of markets change very slowly.

It should follow that the markets with high net entry rates are markets with low structural barriers. The period of positive net entry should, therefore, continue in such markets as long as they continue to grow. Hence a positive correlation should be expected between the two columns in table 1 (duration of period of positive net entry and rate of net entry).

But no such positive correlation appears to exist. The simple correlation between the two columns is -.239. When two outlying observations with unusually high rates of entry were eliminated, the negative value of the correlation coefficient rises to -.38 and is statistically significant at the .01 level. This negative relation should not arouse great interest since it is not very strong. It is not inconsistent, however, with a hypothesis that high entry reflects a high rate of innovation and, hence, a quicker approach to technological maturity of the industry.

There are two types of technical change that produce, or at least contribute to, shifts in sources of innovation, and to changes in the rate of entry. The first is the decline in technological potential as an industry matures. The most promising opportunities for improvements in products and in production processes arise shortly after a technological breakthrough that leads to the introduction of new products. Each new technology has inherent limits in the extent to which it can be pushed forward, and its obsolescence results from the successive decline in the economic importance of the remaining opportunities for further development.

Among the early proponents of this view were Kuznets (1930) and Burns (1934) who explained through this process the decline in the rate of growth of output in new industries as they approached maturity. More recently, Salter (1960) reached a similar conclusion. A hitherto neglected consequence of this process is that, as the economic importance of technical advance declines, the ability of innovators from outside the industry to encroach on the markets of incumbent firms suffers a parallel decline. Incumbent firms, as contrasted with potential entrants, have the advantages of a) goodwill in the market, b) accumulated experience (human capital) acquired through past output, and c) possible advantages, (at least initially) in the form of scale economies, since it takes time for a new entrant to develop a market. The less the economic impact of an innovation, the less will an innovator (from outside the industry) be able to offset these advantages of incumbent firms.


TABLE I

Number of Years and Average Annual Rate of Net Entry in Period of Positive Net Entry for 46 Product Innovations

Ave. Annual Rate

in Period

No. of Years in Period Product Name of Net Entry

Baseboard radiant heating 9 2.1 Compressor, Freon 5 2.2 Computers 8 14.3 Crystals, Piezo 14 3.1 DDT 2 15.0 Electrocardiographs 3 1.3 Electric blankets 4 1.5 Electric shavers 2 15.0 Engines, Jet-propelled 17 1.5 Engines, Rocket 8 1.6 Fluorescent lamps 2 16.0 Freezers, Home and farm 9 5.8 Gauges, Beta-ray 3 2.0 Gyroscopes 9 3.6 Lasers 11 5.6 Machinery, Adding and calculating 3 5.0 Missiles, Guided 8 30.9 Motors, Outboard 4 5.0 Nylon 14 1.7 Paints, Rubber and rubber base 21 4.6

Pens, Ballpoint 18 1.4

Polariscopes 7 1.3 Pumps, Heat 8 2.5 Radar, Marine, airborne, other 10 12.3 Radio transmitters 4 8.5

Readers, Microfilm 13 1.7 Records, Phonograph 3 11.7 Saccharin 2 16.5

Streptomycin 7 1.7

Tanks, Cryogenic 8 10.4 Tapes, Recording 20 2.7

Penicillin 7 3.9

Photocopy machines 23 1.8

Reactors, Nuclear 9 4.9

Shampoo 18 4.9

Styrene 11 1.9

Telemeters 10 1.9 Television, apparatus, parts 6 81 .o Tents, Oxygen 16 1.2

Trees, Artificial Xmas 2 3.5 Tubes, Cathode ray 18 2.0

Wipers, Windscreen 9 5.4 Zippers 25 1.9

Tires, Automobile 16 16.6 Transistors 9 7.1

Turbine, Gas 17 1.7

Mean 9.7 5.67

Source: Drawn from Tables 2 and 3 in M. Gort and S. Klepper, “Time Paths in the Diffusion of Product Innovations,” Economic Journal, 1982, 92, pp. 641-42.


The second type of technical change contributing to structural changes in markets is the gradual proliferation of specialized varieties of a basic new product. It results from the adaptation of products to particular uses, and from the discovery of new uses after a product is introduced. The increasing specialization, as represented in diagram 1, may be viewed as a product tree with each branch generating its sub- classes of increasingly more specialized product derivatives. Diagram 2 describes the growth path in number of sub-products. Since the number of possible varieties within each branch of specialization diminishes at each successive level, the percentage growth rate in number of products diminishes over time until it approaches zero. Hence the percentage growth rate may be described by a hyperbola approaching zero, while the absolute number of products probably will form an S-shaped curve.

The increasing diversity of sub-products as technology evolves has a profound effect on market structure. As specialization increases, familiarity with the market becomes critical in developing the most effective adaptations to narrow uses. Small refinements are frequently decisive in the competition for market share, as are small differences in production costs and, hence, prices. Such refinements in product technology, and in adapting products to diverse user preferences, give an advantage to team effort in contrast with efforts of individual inventors. New firms, without experience in the production and marketing of the product, are increasingly handi- capped relative to incumbent firms. Finally, the narrower the use, the larger must be the market share to permit a sufficient production run for efficient utilization of fixed inputs. Once again, it imposes a handicap on new entrants.

Policy Implications We turn now to a few policy implications. In recent years, most empirical

research on innovation has focused on research and development data and on data for patents. In large part, it stems from the availability of reasonably hard information on both variables. As indicated earlier, however, research and development data relate disproportionately to innovative activity in the stages of a product cycle corres- ponding to technological maturity. Major technical breakthroughs which occur early in the product cycle and result from informal research, or from development that is simply a by-product of experience in production, will not be captured by such information. Since technological opportunities tend to be highest in the early stages of the product cycle, the use of research and development data to explain productivity changes at the macroeconomic level is bound to have only limited success.

The observed correlation between patent frequencies and research and development expenditures found by Scherer (1965) and Schmookler (1966), based on cross- section data, suggests that patent frequencies may be a reasonable index of explicit investment in research and development effort but not, necessarily, of the rate of technical change. Investment in oil drilling supplies is an example. Across companies, the’number of producing wells is likely to be correlated with expenditures on exploration and development. But such expenditures are not likely to be a good index of changes over long periods of time in developed oil reserves since the productivity of investment in oil exploration has been falling steadily.

A related issue arises in connection with government financing of research and development. To the extent that such financing is concentrated on separately budgeted research in specialized laboratories, a more-than-optimal proportion of such outlays may be devoted to mature technologies. Hence, the effect of such financing on changes in productivity may be less than under alternative allocations of financial resources to innovation.


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Policy implications also can be drawn from the effect of technical change on market structure. The authors have indicated that two types of technical change are responsible for a reduction in the rate of entry in a market. Neither lends itself readily to modification by changes in public policy. To the extent, therefore, that these forces explain variations in entry rates, the scope for public policy in dealing with entry barriers is limited.

REFERENCES

Burns, A.F., Production Trends in the United States Since 1870, National Bureau of Economic Research, New York, 1934.

Gort, M. and Klepper, S., “Time Paths in the Diffusion of Product Innovations,” Economic Journal, 1982, 92, 630-53.

Kamien, M.I. and Schwartz, N.L., Market Structure and Innovation, Cambridge University Press, Cam-

Kuznets, S., Secular Movements in Production and Prices, Houghton Mifflin, Boston and New York, 1930. Mueller, D. and Tilton, J . , “Research and Development Costs as a Barrier to Entry,” Canadian Journal of

Pavitt, K. and Wald, S., The Conditions for Success in Technological Innovation, OECD, Paris, 1971. Salter, W.E.G., Productivity and Technical Change, Cambridge University Press, Cambridge, 1960. Scherer, F.M., “Firm Size, Market Structure, Opportunity, and the Output of Patented Inventions,”

Schmookler, J . , Invention and Economic Growth, Harvard University Press, Cambridge, Mass., 1966. Tilton, J., International Diffusion of Technology: The Case of Semiconductors, Brookings Institution,

bridge, 1982.

Economics, 1969, 2, 570-79.

American Economic Review, 1965, 55, 1097-1 125.

Washington, D.C., 1971.

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