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Well, I think we understand what you mean, but R&D costs are sunk costs. They have no relevence when setting prices. If you have a patent on, for example, the

by pravda 13y ago

Well, I think we understand what you mean, but R&D costs are sunk costs. They have no relevence when setting prices. If you have a patent on, for example, the chainsaw, and are the sole manufacture of chainsaws, you can set the price of a chainsaw based solely on how much your tree-cutting-down gizmo is worth to the consumer.

rayiner 13y ago
You're talking about long-run equilibrium which isn't totally relevant here (https://en.wikipedia.org/wiki/Market_power https://en.wikipedia.org/wiki/Market_power). In a perfectly competitive equilibrium market, you're right, producers are price takers. But we're not talking about wheat farming. When we're talking about the introduction of new products, etc, we're necessarily talking about markets that aren't in their long-term equilibrium. Such markets are where all the money is made. E.g. today, the CD drive market is probably in its long-run equilibrium and highly competitive, and there is no profit to be made producing CD drives. But it was a highly lucrative product for Sony when the technology was first introduced. In these contexts, producers do have a certain amount of pricing power, and can extract positive profits as a result. Moreover, even in perfectly competitive markets, where costs are irrelevant to prices, costs are relevant to companies' decisions about whether to engage in R&D. If the market dynamics are such that prices approach marginal cost, there is very little incentive to engage in R&D, because it won't be profitable. As a concrete example, say you're ARM and contemplating investing $1 billion to put a new quad-core 3 GHz 1W CPU on the market. Because this a new product, you have a certain amount of pricing power to begin with. That pricing power allows you to extract positive economic profits, at least until your design is copied and the market becomes highly competitive. For the whole exercise to be worth while, you have to recoup that $1 billion in R&D before the market becomes competitive and prices approach marginal costs of production. If your Chinese competitor can copy your design for $100 million in 6 months, they have a huge advantage. At that point both companies will together likely still have a lot of pricing power, but because your competitor had much lower R&D costs to get the same product, he can undercut you o price and still recoup his lower R&D expense. In that sort of market, the profitable strategy is to copy, not to do original R&D.
- spacelizard 13y ago
  The problem with that example (and that whole line of thinking) is that the $1 billion they put into research was a gamble in the first place and didn't actually give them any pricing power because it has nothing to do with the demand for that product. Why should we care? Knowing the current market it's actually way more likely that that the product flops completely and the $1 billion goes completely to waste. But now because of patents they get to stay in business to repeat this mistake again because they can just extort licensing fees from other companies who want to actually improve this idea and make it marketable. It just doesn't make any sense from any perspective. Demand should be what drives R&D, not profit. When profit drives research that's all you'll get: companies with no products hoarding research (i.e. patents) and just sitting around suing people.
  - rayiner 13y ago
    R&D does give companies pricing power. If you come up with a 3 GHz 1W chip in a market of 2 GHz 3W chips, suddenly your product is non-fungible with all the other competitors, and as a result you can price the product above its marginal cost. Whether it's worthwhile to spend $1 billion doing that depends on how long you can last before all your competitors come up with 3 GHz 1W chips. Because once that happens, competitive pressures will force prices downwards to the marginal costs of production. If that time isn't long enough for you to recoup that R&D, then it's a losing play to be the one that puts in that work. The winning play is to be the company that copies that technology and maybe tweaks it the last 1%. As a practical matter, profit has to drive R&D, because there is no money for R&D without profits. And in perfectly competitive markets, there are no profits and no R&D. The only way to make real money is to produce products that are non-fungible, and differentiable. You can do that in only a few ways: R&D, network effects, marketing, or branding. If you look at the profitable companies in the tech industry, their profits come from one or the other. If you look at the companies that produce fungible products for highly competitive markets (Acer, Lenovo, etc), you see that they their profits are marginal and so is their level of innovation.
jameshart 13y ago
Ah, but not all consumers are equal. You can set your chainsaw price based solely on what a few consumers who REALLY REALLY NEED your chainsaw technology are willing to pay, and make a phenomenal profit margin on those chainsaw sales because you have a legal monopoly on chainsaw manufacturing and they can't get the technology anywhere else. And while there may be other consumers who could afford a chainsaw at a lower price, well, they have to go without because they can't turn to another manufacturer either. As soon as you have to share the marketplace, chainsaws of a given quality become a commodity and your margins are going to come down.
noselasd 13y ago
You have a problem if the price you set didn't recover the R&D costs, the cost to build a chainsaw factory and so on. If it doesn't, embarking on your chainsaw venture was a mistake, serving only to lose your money. The solution to just set a higher price might not work, as people might not be willing to pay that much, or even have that much money.

by pravda 13y ago

rayiner 13y ago

You're talking about long-run equilibrium which isn't totally relevant here (https://en.wikipedia.org/wiki/Market_power https://en.wikipedia.org/wiki/Market_power). In a perfectly competitive equilibrium market, you're right, producers are price takers. But we're not talking about wheat farming. When we're talking about the introduction of new products, etc, we're necessarily talking about markets that aren't in their long-term equilibrium. Such markets are where all the money is made. E.g. today, the CD drive market is probably in its long-run equilibrium and highly competitive, and there is no profit to be made producing CD drives. But it was a highly lucrative product for Sony when the technology was first introduced. In these contexts, producers do have a certain amount of pricing power, and can extract positive profits as a result. Moreover, even in perfectly competitive markets, where costs are irrelevant to prices, costs are relevant to companies' decisions about whether to engage in R&D. If the market dynamics are such that prices approach marginal cost, there is very little incentive to engage in R&D, because it won't be profitable. As a concrete example, say you're ARM and contemplating investing $1 billion to put a new quad-core 3 GHz 1W CPU on the market. Because this a new product, you have a certain amount of pricing power to begin with. That pricing power allows you to extract positive economic profits, at least until your design is copied and the market becomes highly competitive. For the whole exercise to be worth while, you have to recoup that $1 billion in R&D before the market becomes competitive and prices approach marginal costs of production. If your Chinese competitor can copy your design for $100 million in 6 months, they have a huge advantage. At that point both companies will together likely still have a lot of pricing power, but because your competitor had much lower R&D costs to get the same product, he can undercut you o price and still recoup his lower R&D expense. In that sort of market, the profitable strategy is to copy, not to do original R&D.

spacelizard 13y ago
The problem with that example (and that whole line of thinking) is that the $1 billion they put into research was a gamble in the first place and didn't actually give them any pricing power because it has nothing to do with the demand for that product. Why should we care? Knowing the current market it's actually way more likely that that the product flops completely and the $1 billion goes completely to waste. But now because of patents they get to stay in business to repeat this mistake again because they can just extort licensing fees from other companies who want to actually improve this idea and make it marketable. It just doesn't make any sense from any perspective. Demand should be what drives R&D, not profit. When profit drives research that's all you'll get: companies with no products hoarding research (i.e. patents) and just sitting around suing people.
- rayiner 13y ago
  R&D does give companies pricing power. If you come up with a 3 GHz 1W chip in a market of 2 GHz 3W chips, suddenly your product is non-fungible with all the other competitors, and as a result you can price the product above its marginal cost. Whether it's worthwhile to spend $1 billion doing that depends on how long you can last before all your competitors come up with 3 GHz 1W chips. Because once that happens, competitive pressures will force prices downwards to the marginal costs of production. If that time isn't long enough for you to recoup that R&D, then it's a losing play to be the one that puts in that work. The winning play is to be the company that copies that technology and maybe tweaks it the last 1%. As a practical matter, profit has to drive R&D, because there is no money for R&D without profits. And in perfectly competitive markets, there are no profits and no R&D. The only way to make real money is to produce products that are non-fungible, and differentiable. You can do that in only a few ways: R&D, network effects, marketing, or branding. If you look at the profitable companies in the tech industry, their profits come from one or the other. If you look at the companies that produce fungible products for highly competitive markets (Acer, Lenovo, etc), you see that they their profits are marginal and so is their level of innovation.

jameshart 13y ago

Ah, but not all consumers are equal. You can set your chainsaw price based solely on what a few consumers who REALLY REALLY NEED your chainsaw technology are willing to pay, and make a phenomenal profit margin on those chainsaw sales because you have a legal monopoly on chainsaw manufacturing and they can't get the technology anywhere else. And while there may be other consumers who could afford a chainsaw at a lower price, well, they have to go without because they can't turn to another manufacturer either. As soon as you have to share the marketplace, chainsaws of a given quality become a commodity and your margins are going to come down.

noselasd 13y ago

You have a problem if the price you set didn't recover the R&D costs, the cost to build a chainsaw factory and so on. If it doesn't, embarking on your chainsaw venture was a mistake, serving only to lose your money. The solution to just set a higher price might not work, as people might not be willing to pay that much, or even have that much money.