SECOND YEAR EXAMINATIONS 2018/19

MANAGEMENT OF NEW TECHNOLOGY

1.  Answer parts (a) to (e) of this question.

Let a firm in a perfectly competitive industry have a production function that can be written: Q = 2L + 4K, where Q is output, L is labour and K is capital.

(a)  [10 marks] Illustrate in a graph the combinations of labour and capital that result in an output of 100 units.

ANSWER: 4K = 100 - 2L - K = 25 - L/2

Graph of the isoquant.  x-axis is L, y-axis is K.  The intercept is at 25 and the slope is 1/2.

(b)  [10 marks] Calculate the marginal product of labour and capital.

ANSWER: MPL =  = 2 and MPK =  = 4

(c)  [10 marks] Suppose now that a technological change occurs so that the combinations of labour and capital that result in an output of 100 units can be written 100 = L + 4K. Illustrate the change on the same graph.

ANSWER: 4K = 100 - L - K = 25 - L/4.  The new isoquant for Q = 100 has an intercept at 25 and a slope of 1/4.

(d)  [10 marks] Calculate the new marginal product of labour and capital.

ANSWER: The new MPL =  = 1 whereas the MPK =  = 4

(e)  [10 marks] Describe the type of technological change that has occurred.

ANSWER: Labour saving technological progress as the producers can now produce the same amount with relatively less labour input.

2.  Answer parts (a) to (c) of this question.

Suppose that two innovation opportunities exist, each costing £100 in initial outlay, but gener- ating different possible returns. Investment A generates a return of £150 with probability 0.5 and £100 with probability 0.5, while investment B generates a return of £180 with probability 0.5 and £10 with probability 0.5.

(a)  [10 marks] Define and calculate the expected return for each investment.

ANSWER: Expected return of A = 150 . 0.5 + 100 . 0.5 - 100 = 75 + 50 - 100 = 25 Expected return of B = 180 . 0.5 + 10 . 0.5 - 100 = 90 + 5 - 100 = -5

(b)  [30 marks] Compare and contrast the investment choice of a self-financed investor and an investor financed by debt. Explain your reasoning carefully.

ANSWER: A self–financed investor would never choose project B since it gives neg- ative net expected return.

An investor financed by debt will undertake project B .

Expected return of A = 150 . 0.5 + 100 . 0.5 - 100 - X = 25 - X

Expected return of B = 180 . 0.5+10 . 0.5 - (100 . 0.5+10 . 0.5) -X = 90+5 - 55 -X =

40 - X

(c)  [10 marks] What does your analysis in part (b) imply for the financing of new techno- logical investment?

ANSWER: Under debt financing the innovator earns more by undertaking a “bad" project, although a lender should never which to finance a “bad" project. This shows the adverse selection (asymmetric information) which occurs in the financing of projects.

3.  Answer parts (a) to (d) of this question.

“If we take into account that an important function of formal research and development is to increase a firm’s absorptive capacity, then knowledge spillovers should increase, rather than decrease, the incentive to conduct formal research and development."

(a)  [10 marks] Explain what is meant by a firm’s “absorptive capacity".

ANSWER: Absorptive capacity is the fraction of knowledge in the public domain that the firm is able to assimilate and exploit

(b)  [10 marks] What are the main determinants of a firm’s absorptive capacity?

ANSWER: The firm’s absorptive capacity is determined by the characteristics of the underlying scientific and technological knowledge that affect the ease of learning from the environment

(c)  [20 marks] Explain why it might be the case that an increase in knowledge spillovers would be associated with an increasing incentive to conduct research and development (R&D)?

ANSWER: More spillovers imply that a firm has more to learn from others.  This in- creases the incentive for own R&D because own R&D enhances a firm’s absorptive capacity.

(d)  [10 marks] Is there empirical support for the above quotation?

ANSWER: The absorption role of R&D exists, but it does not outweigh its generation of innovations role.

4.  Answer parts (a) and (b) of this question.

Venture capitalists rely relatively heavily on criteria relating to characteristics of the inventor (for example, whether he/she is capable of sustained effort) when deciding whether to fund a new innovation-based venture.  On the other hand, internal review procedures tend to rely relatively heavily on criteria relating to characteristics of the invention (for example, whether the invention is technically feasible).

(a)  [25 marks] Explain the meaning of the terms “adverse selection" and “moral hazard".

ANSWER: Adverse selection is opportunism characterised by an informed party’s ben- efiting from trading or otherwise contracting with a less informed person who does not know about an unobserved characteristic of the informed party

Moral hazard is opportunism characterised by an informed party’s benefiting from trad- ing or otherwise contracting with a less informed person through an unobserved action.

(b)  [25 marks] Describe the main characteristics of venture capital. In what sense can ven- ture capital be seen as a response to adverse selection and moral hazard in the market for funding new innovations?

ANSWER: Venture capital is a type of private equity funding provided by individuals or institutional investors (often through specialised venture capital firms) to new, rapidly growing companies in high technology industries.

Venture capitalists generally 1. provide cash in exchange for shares in the invested com- pany, 2. may also take a role in the management of the company, 3. may have technical expertise and assist in the development of new products or services, 4.  take high risks with the expectation of high rewards, 5. have a long–term orientation.

Venture capitalist help alleviate problems of asymmetric information in the funding of innovations because usually knowledgeable about industry in which they invest and have high level of informed monitoring.

5.  Answer parts (a) to (d) of this question.

Consider a pharmaceutical firm that is financing research for a new vaccine.

(a)  [10 marks] Describe the type of externality and the consequences on firms’ productions.

ANSWER: positive production externality (knowledge spillovers) leading to an under- production of R&D

(b)  [20 marks] Draw the demand and supply graph and show the deadweight loss.

ANSWER: