Unit 2 Technology and incentives

2.6 Modelling a dynamic economy: Innovation and profit

A change in the relative prices of labour and energy will change the slope of the firm’s isocost lines. Looking at the positions of the three technologies in Figure 2.9, we can imagine that if the isocost line becomes steep enough (w/p rises, so coal becomes relatively cheaper), B will no longer be the least-cost technology: the firm will switch to A. This is what happened in England in the eighteenth century.

Suppose that the price of coal falls to £5, while the wage remains at £10.

From the table in Figure 2.9, with the new prices technology A allows the firm to produce 100 metres of cloth at least cost. Cheaper coal makes each method of production cheaper, but the energy-intensive technology is now cheapest.

Remember that to draw the isocost line through any point, such as A, we calculate the cost at A (£40) then find another point with the same cost. The easiest way is to find one of the end points, F or G. For example, if no coal was used, four workers could be hired for £40. This is point F.

Figure 2.9 shows that with the new relative price, technology A lies on the £40 isocost line, and the other two available technologies lie above it. They will not be chosen if technology A is available.

How does a cost-reducing innovation raise profits?

Now we can calculate the gains to the first firm to adopt the least-cost technology (A) when the relative price of labour to coal rises. Like its competitors, the firm is initially using technology B and minimizing its costs: this is shown in Figure 2.10 by the dashed isocost line through B (with end points H and J).

Once the relative price changes, the new isocost line through technology B is steeper and the cost of production is £50. Switching to the energy-intensive technology A reduces costs to £40 for 100 metres of cloth. Follow the steps in Figure 2.10 to understand how isocost lines change with the new relative prices.

The firm’s profits are equal to the revenue it gets from selling output, minus its costs.

Whether the newer, less labour-intensive technology or the older one is used, cloth is sold at the same price, and the same prices have to be paid for labour and coal. The change in profit is therefore equal to the fall in costs associated with adopting the new technology, and profits rise by £10 per 100 metres of cloth:

\[\begin{align*} \text{profit} &= \text{revenue} - \text{costs} \\ \text{change in profit from} \\ \text{switching from B to A} &= \text{change in revenue — change in costs} \\ &= 0-(40-50) \\ &= 10 \end{align*}\]

In this case, the economic rent for a firm switching from B to A is £10 per 100 metres of cloth, which is the cost reduction made possible by the new technology. The decision rule (remember, if the economic rent is positive, do it!) tells the firm to innovate.

entrepreneur

A person who creates or is an early adopter of new technologies, organizational forms, and other opportunities.

In our example, technology A was available, but not in use until a first-adopter firm responded to the incentive created by the increase in the relative price of labour. The first adopter is called an entrepreneur. When we describe a person or firm as entrepreneurial, it refers to a willingness to try out new technologies and to start new businesses.

The economist Joseph Schumpeter (discussed in the ‘Great economists’ box later in this section) made the adoption of technological improvements by entrepreneurs a key part of his explanation for the dynamism of capitalism. For this reason, innovation rents are often called Schumpeterian rents.

Innovation rents do not last forever. Other firms, noticing that entrepreneurs are making economic rents, will eventually adopt the new technology—and thereby reduce their costs and increase their profits.

creative destruction

Joseph Schumpeter’s name for the process by which old technologies and the firms that do not adapt are swept away by the new, because they cannot compete in the market. In his view, the failure of unprofitable firms is creative because it releases labour and capital goods for use in new combinations.

Then, with higher profits per 100 metres of cloth, the lower-cost firms will thrive. They will increase their output of cloth. As more firms introduce the new technology, the supply of cloth to the market increases. With more cloth available for sale, the price will start to fall. This process will continue until everyone is using the new technology. Once cloth prices have declined to the point where no one is earning innovation rents, firms that stuck to the old technology B will be unable to cover their costs, and they will go bankrupt. Joseph Schumpeter called this creative destruction.