Question

The inverted-U theory suggests that R&D expenditures as a percentage of sales ________ with industry concentration after the four-firm concentration ratio exceeds about 50 percent. a. Rise. b. Fall. c. Fluctuate. d. Flat-line.

Short answer

The correct answer is b. Fall.

Step-by-step solution

Understanding the Inverted-U Theory

The inverted-U theory, particularly in the context of R&D expenditures, relates the level of R&D spending as a percentage of sales to industry concentration. The industry concentration is often measured by the four-firm concentration ratio, which indicates the market share of the four largest firms in an industry.

Analyzing the Four-Firm Concentration Ratio

The four-firm concentration ratio signifies the percentage of total industry sales controlled by the top four companies. When this ratio exceeds a certain threshold, it suggests a highly concentrated industry.

Implications of High Industry Concentration

According to the inverted-U theory, there is an optimal level of industry concentration where R&D spending is maximized. Beyond this point, especially when the concentration ratio exceeds 50%, R&D expenditures tend to decrease, indicating a fall after this threshold.

Selecting the Correct Option

Given the relationship described by the inverted-U theory – where R&D spending decreases after a certain industry concentration level – the correct option is 'b. Fall.'

Key concepts

Inverted-U Theory

The Inverted-U Theory offers an insightful perspective on how research and development (R&D) expenditures are influenced by market structures. This theory suggests that R&D activity is not linearly associated with industry concentration levels. Instead, there is a particular concentration point where R&D investment reaches its peak. As industry concentration increases initially, R&D spending also rises. This is because firms are trying to innovate and maintain their competitive edge.
However, as the concentration continues to grow and surpasses a certain threshold, the theory predicts that R&D spending will begin to decline. This is visually represented as an inverted-U shape when graphed, illustrating that after a certain point, more concentration can lead to less innovation. This shape emerges because firms become too dominant and comfortable, reducing the motivation to innovate.

• Theory explains non-linear relationship between R&D and market concentration.
• Represents peak investment followed by decline as firms become too dominant.

Industry Concentration

Industry concentration refers to the extent to which a small number of firms dominate a particular market. It provides insight into how competitive or monopolistic a market might be. High industry concentration signifies that a few firms hold a large portion of the market share, which can lead to less competitive behavior. When fewer companies control the industry, they may have greater power to set prices and influence market trends. The level of concentration in an industry affects innovation and R&D spending. A moderate level of concentration can encourage firms to invest in R&D to differentiate themselves from competitors.
But if concentration gets too high, these incentives diminish because the dominant firms face little to no competitive pressure. Recognizing the concentration level in an industry is essential for understanding its dynamics.

• Defines market competitiveness by firm dominance.
• Influences firm motivation regarding innovation and pricing.
• Significant for assessing market health and innovation potential.

Four-Firm Concentration Ratio

The Four-Firm Concentration Ratio is a straightforward metric to assess industry concentration. It calculates the total market share that the four largest firms in an industry hold. This metric is crucial because it offers a simple way to understand how concentrated an industry is, without diving into complex calculations. To interpret this ratio:

• A low value indicates a competitive market with many players.
• A high value suggests that a few firms control a significant portion of the market.

When this ratio exceeds 50%, it suggests a high level of concentration, often leading to reduced competitive pressures. Beyond this point, according to the Inverted-U Theory, R&D spending tends to decline. This happens because firms become complacent, having already secured a substantial market share.

Optimal Level of R&D

Understanding the optimal level of R&D investment is critical for firms seeking to maximize innovation and maintain competitive advantages. Optimal R&D is the investment level where firms get the most benefit from their research efforts without overspending. In an industry context:

• Firms must invest enough in R&D to stay ahead or keep pace with competitors.
• An optimal level of R&D is where returns outweigh the costs.

According to the Inverted-U Theory, this optimal point is affected by industry concentration. If concentration is moderate, firms are incentivized to invest in R&D to differentiate their products. However, when concentration gets too high, the incentives for heavy R&D spending decrease because firms already control a significant market share and may not need to innovate as aggressively.