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7 A Framework for Examination of the Impacts of Government Regulation and Input Prices on Process

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Innovation EDWARD GREENBERG Department of Economics, Washington University, St. Louis, MO 63130 Recent years have witnessed a considerable effort to determine the effect of government regulation on product innovation, but little has been done with respect to process innovation. In this paper, a framework for an analysis of this type i s described and i s applied to process change i n the production of anhydrous ammonia. The ideas i n the paper are more f u l l y developed i n (1). In the context of chemical production, a process innovation may be defined as an addition to knowledge which allows some quantity of output to be produced by an input combination that could not previously be used to produce that output. For an innovation to be economically interesting, the innovation should result i n a lower cost of production than other techniques at some combination of input prices. Whether the innovation i s actually used i n production will depend on a host of factors, including the patterns of input prices which producers face and the desirability of adding to capacity at the time that input prices favor the innovative technology. This last point assumes --often r e a l i s t i c a l l y , for chemical processes--that innovations frequently require changes i n plant and equipment that would be undertaken only if j u s t i f i e d by expected demand growth. In principle, innovation should be distinguished from subs t i t u t i o n , where the latter refers to a switch to a previously known production technique. Changes i n relative input prices would be a reason for substitution, as would an increase i n output sufficient to make it profitable to move to a more highly capital-intensive method of production. The distinction turns on the extent to which properties of the process to be used are already known. In practice, the distinction may not be clear-cut. Even simple substitution may involve some degree of uncertainty; some properties of the new process may remain unknown u n t i l it i s physically implemented. It i s necessary to draw this distinction for the light it sheds on the effects of those government regulations that are concerned with workplace safety and health and with environmental 0-8412-0511-6/79/47-109-103$05.00/0 © 1979 American Chemical Society

Hill; Federal Regulation and Chemical Innovation ACS Symposium Series; American Chemical Society: Washington, DC, 1979.

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p r o t e c t i o n . Changes i n such r e g u l a t i o n s may induce s u b s t i t u t i o n * For example, a r e g u l a t i o n designed to improve worker s a f e t y and h e a l t h may r e q u i r e a change to a more c a p i t a l - i n t e n s i v e process that both reduces the number of exposed workers and reduces the p r o b a b i l i t y of t h e i r exposure to a s a f e t y or h e a l t h hazard, whether government r e g u l a t i o n can have an impact on innovation i s another question. Since we have defined innovation as an increase i n knowledge, we must consider how r e g u l a t i o n can a f f e c t the behavior of those people engaged i n the production of know ledge. Determinants of

Innovation

A first p o i n t to note i s the i m p l i c i t assumption that a c t i v i t i e s of producers of knowledge can be a f f e c t e d by govern ment r e g u l a t i o n s through t h e i r i m p l i c a t i o n s f o r the p o s s i b i l i t y of using the knowledge i n f u t u r e production. In t h i s view, knowledge does not r e s u l t s o l e l y from engineers and s c i e n t i s t s who indulge t h e i r own c u r i o s i t i e s and s c i e n t i f i c c r e a t i v i t y ; r a t h e r , it assumes that at l e a s t some knowledge i s gained from a p u r p o s e f u l search f o r new methods of production that will be c o n s i s t e n t with government r e g u l a t i o n s . I f the p o s s i b i l i t y i s granted t h a t innovative a c t i v i t y i s not the r e s u l t of s c i e n t i s t s and engineers' random a c t i v i t i e s , it becomes necessary to i d e n t i f y f a c t o r s other than government r e g u l a t i o n that may i n fluence i n n o v a t i o n . This i s so because e m p i r i c a l s t u d i e s that attempt t o q u a n t i f y the r o l e of r e g u l a t i o n i n s t i m u l a t i n g or r e t a r d i n g innovation must c o n t r o l — s t a t i s t i c a l l y or i n some other w a y — f o r changes i n such f a c t o r s that happen to occur concurrently with changes i n r e g u l a t o r y a c t i v i t y . In the standard economic model of the f i r m , business d e c i s i o n s are g e n e r a l l y explained by t h e i r e f f e c t s on expected p r o f i t a b i l i t y . Let us examine some ways i n which i n n o v a t i v e a c t i v i t y and expected p r o f i t a b i l i t y i n t e r a c t : 1. Expected demand i n c r e a s e s : an i n d u s t r y t h a t i s ex pected t o grow i s l i k e l y to a t t r a c t resources f o r the purpose of improving production processes, s i n c e cost savings will be g r e a t e r at a greater volume of output (2,3). 2. Cumulative output: an i n d u s t r y that has produced l a r g e q u a n t i t i e s of a product may experience reductions i n i t s r e q u i r e d i n p u t s . One explanation i s " l e a r n i n g by doing" i n p l a n t operations; a second p o s s i b l e cause i s " l e a r n i n g by doing" by firms t h a t produce c a p i t a l goods f o r the i n d u s t r y i n question. That i s , as c a p i t a l goods producers supply a l a r g e number of u n i t s to an i n d u s t r y , they l e a r n how to improve the performance of t h e i r products (2 ».4>5.»ίί) . 3. Input p r i c e s : the l i t e r a t u r e on induced t e c h n i c a l change takes the view that the d i r e c t i o n of t e c h n i c a l change—whether it i s c a p i t a l or energy saving, f o r example —may be i n f l u e n c e d by input p r i c e s (7.»δ.»£). * a d d i t i o n 1

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t o i n f l u e n c i n g the d i r e c t i o n of t e c h n i c a l change, changes i n input p r i c e s may i n c r e a s e the payoff to p r o c e s s - o r i e n t e d research i n g e n e r a l , r e s u l t i n g i n f a c t o r - s a v i n g i n n o v a t i o n . From t h i s d i s c u s s i o n it should be c l e a r t h a t there e x i s t a number of economic v a r i a b l e s t h a t could a f f e c t the o v e r a l l amount of i n n o v a t i v e a c t i v i t y and i t s d i s t r i b u t i o n across indus t r i e s , and whether it emphasizes the saving of one or another f a c t o r of p r o d u c t i o n . A number of other economic f a c t o r s a f f e c t i n n o v a t i o n , of which the most important i s market s t r u c t u r e . Research i n t h i s area has r e c e n t l y been reviewed (10). The preceding has emphasized what Rosenberg has termed the demand f o r i n n o v a t i o n (11). He p o i n t s out that the supply of s c i e n t i f i c knowledge i n t e r a c t s with that demand to determine the i n n o v a t i o n a c t u a l l y achieved. However, supply and demand f o r i n n o v a t i o n are extremely d i f f i c u l t to d i s e n t a n g l e i n p r a c t i c e . Thus, m e t a l l u r g i c a l and other types of knowledge were r e q u i r e d to produce tubes capable of withstanding the high pressures and temperatures that are needed f o r the high pressure reforming stage i n ammonia p r o d u c t i o n . But, to some degree, development of such tubes was undertaken with an eye on the ammonia market. In other cases, ammonia may have b e n e f i t t e d from attempts to improve other processes. F i g u r e 1 presents a view of the main f a c t o r s determining process change. I t d e p i c t s the exogenous i n f l u e n c e on expected future p r o f i t a b i l i t y of demand c o n d i t i o n s , f a c t o r p r i c e changes, and government r e g u l a t i o n , w i t h the l a t t e r two a l s o i n f l u e n c i n g the d i r e c t i o n of i n n o v a t i o n . Expected p r o f i t a b i l i t y helps determine the amount of resources to a l l o c a t e to process innova t i o n and the amount of investment i n new p l a n t and equipment. In t u r n , the l a t t e r s t i m u l a t e s process R&D through the " l e a r n i n g by doing" route mentioned above. A Production Model f o r Chemical

Processes

Although i n n o v a t i o n i s an extremely complex a c t i v i t y , some s i m p l i f i c a t i o n can be achieved f o r purposes of e m p i r i c a l study by d e l i n e a t i n g c a t e g o r i e s of i n n o v a t i o n i n the context of a model of p r o d u c t i o n . Production i s assumed to take p l a c e w i t h i n a f i n i t e set of w e l l - d e f i n e d processes, r a t h e r than on a smooth n e o c l a s s i c a l production f u n c t i o n . In t h i s r e s p e c t , the model i s a v e r s i o n of the " a c t i v i t y a n a l y s i s " model. In c o n t r a s t to the u s u a l a c t i v i t y a n a l y s i s model, however, some of the inputs are c h a r a c t e r i z e d by i n c r e a s i n g r e t u r n s to s c a l e . Specifically, engineers o f t e n assume that c a p i t a l and labor (and perhaps other inputs) may be i n c r e a s e d at a slower r a t e than output, while raw m a t e r i a l s , energy, and other i n p u t s are increased a t the same or n e a r l y the same r a t e as output. The economics l i t e r a t u r e on production f u n c t i o n s d i s c u s s e s these p o i n t s (12,13,14). Assuming two inputs f o r s i m p l i c i t y , we designate the " l i n e a r " input by Ν and the " n o n l i n e a r " input by K. A first


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Demand C o n d i t i o n s (output market)

Input

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Profi tabi 1 ity

• Regulation of| process tech nology

P r o c e s s R&D

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Mew P r o c e s s Technology

Investment i n C a p i t a l Goods T h a t I n c o r p o r a t e New Technology

Figure 1.

Factors influencing process innovation


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approximation to the production f u n c t i o n f o r the i t h process i s :

where QJL i s output from the i process and 0 < b^ < 1. The c o e f f i c i e n t s a ^ , a j ^ , and completely c h a r a c t e r i z e the i technology i n economic terms. For a given input of Ν and K, t h i s f u n c t i o n s t a t e s that output will be the smaller of N / a and [K/a^jJ 1/bi. it does not permit t r a d e o f f s between these two inputs w i t h i n a p a r t i c u l a r process. However, unless b^ » 1, the r a t i o of inputs v a r i e s with output. In p a r t i c u l a r , K/N decreases with output along a given process f o r b^ < 1. (Engineering pro d u c t i o n processes may be c h a r a c t e r i z e d i n dimensions other than t h e i r primary inputs and outputs. They are a s s o c i a t e d with d i f ferences i n at l e a s t the f o l l o w i n g : e f f l u e n t s , requirements f o r s k i l l e d l a b o r , r e l i a b i l i t y , s a f e t y , a d a p t a b i l i t y to use of a l t e r n a t i v e feedstocks, and s e n s i t i v i t y of c o s t s t o l e s s - t h a n - f u n c a p a c i t y production.) T h i s model i s d i s p l a y e d i n F i g u r e 2. The process l i n e s represent combinations of Ν and Κ which s a t i s f y N/a ^ ( K / a ^ j [ ) / i . Since output i s equal to the s m a l l e r of these two v a l u e s , e q u a l i t y of the r a t i o s i m p l i e s no redundant i n p u t s . Out put i s p r o p o r t i o n a l to the v e r t i c a l a x i s , s i n c e « N/a ^, but the p r o p o r t i o n a l i t y f a c t o r d i f f e r s f o r each process. The expo nent, b i , i s u s u a l l y found to be approximately .6 or .7 if Κ represents p l a n t and equipment measured i n d o l l a r s . Because of the i n c r e a s i n g r e t u r n s to Κ when b^ < 1, it will g e n e r a l l y not be p r o f i t a b l e to produce output by u s i n g more than one process, so that many combinations of i n p u t s will not be u t i l i z e d when a small number of processes are a v a i l a b l e . Subject to m o d i f i c a t i o n concerning s u b s t i t u t i o n p o s s i b i l i t i e s noted below, the model we have i n mind i s of the " p u t t y c l a y " v a r i e t y . That i s , although there i s a choice of coef f i c i e n t s before a process i s i n s t a l l e d , the c o e f f i c i e n t s are f i x e d t h e r e a f t e r . T h i s type of model has r e c e n t l y been examined by Myers and Nakamura (15). T h e i r model permits a much wider scope f o r choice of c o e f f i c i e n t s than the l i m i t e d s e t a c t u a l l y a v a i l a b l e f o r producing most chemical products. Two m o d i f i c a t i o n s must be made to t h i s model to make it conform more c l o s e l y to engineering p r a c t i c e . F i r s t , there are upper and lower l i m i t s t o the output p o s s i b l e from a given pro cess at any p o i n t i n time. Second, a c e r t a i n amount of w i t h i n process s u b s t i t u t i o n between inputs i s p o s s i b l e . T h i s type of s u b s t i t u t i o n permits a degree of v a r i a t i o n i n a and a ^ , but these v a r i a t i o n s are s m a l l r e l a t i v e to the d i f f e r e n c e s i n coef f i c i e n t s between processes. The e x i s t e n c e of upper and lower bounds on the s c a l e of a p a r t i c u l a r process may be e x p l a i n e d by a combination of t e c h n i c a l t

h

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Figure 2.

Process model


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and economic reasons. To some extent the bounds are a s i m p l i f i e d method of i n d i c a t i n g a sharp n o n l i n e a r i t y i n the p r i c e of c a p i t a l equipment when nonstandardized u n i t s must be ordered. T h i s may make the cost of the r e s u l t i n g input combination so high that it would not be used i n the short run. In other cases, b u i l d i n g equipment at very small (or very large) s c a l e i s beyond the s t a t e of engineering c a p a b i l i t y . Upper bounds on process s i z e are of p a r t i c u l a r i n t e r e s t s i n c e , i n the presence of i n c r e a s i n g r e t u r n s to s c a l e , one might expect that p l a n t s i z e would increase to the p o i n t that j u s t one p l a n t produces all the output, A number of f a c t o r s c o n s t r a i n t h i s growth. F i r s t i s the high cost of using nonstandard s i z e s , or indeed, the high cost of producing made-to-order equipment much l a r g e r than that which i s o r d i n a r i l y produced. Costs of production, s h i p p i n g , and i n s t a l l a t i o n of such equipment may r i s e f a s t e r than s c a l e ; we t r e a t t h i s as a c o n s t r a i n t r a t h e r than a n o n l i n e a r i t y i n the p r i c e of the i n p u t . Second, there i s the problem of r e l i a b i l i t y . I f a malfunction occurs i n one of two 1500 t.p.d. (tons per day) p l a n t s , f o r example, only h a l f of the production i s l o s t compared t o the l o s s from the shutdown of a s i n g l e 3000 t.p.d. p l a n t . A t h i r d c o n s i d e r a t i o n i s the a b i l i t y to operate at l e s s than f u l l c a p a c i t y and the s e n s i t i v i t y of costs t o l e s s than f u l l c a p a c i t y o p e r a t i o n , if it should become d e s i r a b l e to produce at l e s s than f u l l c a p a c i t y . Average costs at l e s s than f u l l c a p a c i t y are, of course, s e n s i t i v e to the r e l a t i o n s h i p between the f i x e d and v a r i a b l e costs of a process. In p r a c t i c e , market s i z e and t r a n s p o r t a t i o n costs r a t h e r than t e c h n i c a l f a c t o r s may set the most s i g n i f i c a n t l i m i t s on maximum p l a n t s i z e , whereas the u n i t production costs i m p l i e d by the model decrease, the r a t e of decrease slows. The gains from i n c r e a s i n g s c a l e , f o r a given process, becomes l e s s and l e s s important. At the same time, if the p l a n t ' s production will be a l a r g e p o r t i o n of the t o t a l market, or if customers will be very large d i s t a n c e s away from the p l a n t , the net p r i c e r e c e i v e d by the producer may f a l l . Thus the marginal revenue may f a l l f a s t e r than marginal c o s t , y i e l d i n g an economic upper l i m i t to production. The second m o d i f i c a t i o n to the i n c r e a s i n g returns a c t i v i t y a n a l y s i s model i s the p o s s i b i l i t y of s u b s t i t u t i o n among inputs along a given process ray. For example, it may be p o s s i b l e to use l e s s feedstock and more f u e l to produce the same output from f i x e d c a p i t a l equipment. The extent of t h i s s u b s t i t u t i o n i s l i m i t e d by p h y s i c a l and chemical laws, as w e l l as by l e g a l r e s t r i c t i o n s and by equipment l i m i t s i n the short run. One k i n d of s u b s t i t u t i o n between market inputs i s what might be c a l l e d the "make or buy" d e c i s i o n . Depending upon l o c a l cond i t i o n s , a f i r m may f i n d it p r o f i t a b l e to buy untreated water f o r i t s b o i l e r s and do i t s own treatment, or to buy t r e a t e d water from a utility. S i m i l a r l y , a f i r m may buy all of i t s c o o l i n g water requirements from a utility, or it may r e c i r c u l a t e


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c o o l i n g water and buy only make-up water, supplying the c o o l i n g towers and the e l e c t r i c power necessary to operate them. In both cases the f i r m i s buying inputs f o r the purpose of c o o l i n g ; i n terms of market behavior, however, t h i s a c t i v i t y may show up as e i t h e r l a r g e purchases of t r e a t e d water or s m a l l e r purchases of water and g r e a t e r expenditures on c a p i t a l and e l e c t r i c i t y . The d e c i s i o n will be i n f l u e n c e d by such c o n d i t i o n s as l o c a l p r i c e s and r e g u l a t i o n s . A second type of s u b s t i t u t i o n occurs i n the form of s u b s t i t u t i o n s of subprocesses w i t h i n a p a r t i c u l a r process. For examp l e , one step i n the steam reforming process f o r ammonia production i s the removal of carbon monoxide and carbon d i o x i d e from the s y n t h e s i s gas. A number of processes, which d i f f e r somewhat i n energy and c a p i t a l requirements, have been developed f o r t h i s purpose. A t h i r d k i n d of s u b s t i t u t i o n i s the p o s s i b i l i t y of changing operating c o n d i t i o n s w i t h i n a p a r t i c u l a r process, r e s u l t i n g i n moderate changes i n c o e f f i c i e n t s . The most important example i n ammonia p r o d u c t i o n i s the choice of pressure a t which the steam system i s operated; c o e f f i c i e n t s of c a p i t a l , f u e l , and c o o l i n g water f o r producing one ton of ammonia depend on steam p r e s s u r e . I m p l i c a t i o n s of the Production Model f o r Process Innovation The p r o d u c t i o n model j u s t d i s c u s s e d permits the c l a s s i f i c a t i o n of innovations i n t o four main c a t e g o r i e s . The most obvious type of i n n o v a t i o n i s one which reduces the amount of one or more i n p u t s r e q u i r e d f o r the i process; that i s , one which reduces the a f , a ^ , or b^. For example, such innovations may r e s u l t from improvements i n c a t a l y s t s , or from improvements i n the p h y s i c a l arrangements or e f f i c i e n c i e s of equipment. A second type of i n n o v a t i o n i s an i n c r e a s e i n the s u b s t i t u t i o n p o s s i b i l i t i e s w i t h i n a p a r t i c u l a r process; s u b s t i t u t i o n of energy f o r c a p i t a l i s an example, whether an instance of such s u b s t i t u t i o n i s an i n n o v a t i o n or merely a s u b s t i t u t i o n as the term i s used i n the u s u a l theory of production depends on the extent of research and development necessary t o implement it. A t h i r d type of i n n o v a t i o n i s concerned w i t h attempts to weaken the c a p a c i t y c o n s t r a i n t s at both upper and lower l i m i t s . At the upper l i m i t , weakening a c o n s t r a i n t will reduce u n i t costs on the assumption that the p r o d u c t i o n r e l a t i o n s h i p holds at g r e a t e r s i z e s w i t h approximately the same c o e f f i c i e n t s that c h a r a c t e r i z e d s m a l l e r outputs. Production beyond e x i s t i n g upper l i m i t s , as noted above, may be a s s o c i a t e d with d i f f i c u l t e n g i neering problems. Expansion of output by moving along a process curve may not be p o s s i b l e because of a d d i t i o n a l s t r e s s e s put on equipment. In a d d i t i o n , attempts to reduce the minimum s c a l e at which a process may be operated may a l s o be worthwhile because of l o c a l c o n d i t i o n s which both j u s t i f y a s m a l l e r output than may be produced by a given process and make a process a t t r a c t i v e t

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because of r e l a t i v e input p r i c e s . A f o u r t h type of i n n o v a t i o n i s one which r e s u l t s i n an ent i r e l y new process i n the engineering sense. A l l the process c o e f f i c i e n t s may be very d i f f e r e n t ; i n f a c t , e n t i r e l y d i f f e r e n t inputs may be used, or new p h y s i c a l or chemical p r i n c i p l e s may be employed. In c o n t r a s t to production o f ammonia from c o a l , steam reforming of n a t u r a l gas was such an i n n o v a t i o n , as was the s h i f t from p r o p e l l o r t o j e t a i r c r a f t . Current r e s e a r c h to produce n i t r o g e n - f i x i n g (ammonia-producing) b a c t e r i a t h a t a r e symbiotic with corn through DNA manipulation i s i n n o v a t i v e a c t i v i t y o f the f o u r t h type. The first two types o f i n n o v a t i o n noted above a r e s i m i l a r to those u t i l i z e d i n the i n n o v a t i o n models of Nelson and Winter (8) and Binswanger (9). These models are concerned w i t h movements of input c o e f f i c i e n t s w i t h i n a r e g i o n c l o s e t o t h e i r i n i t i a l v a l u e s . However, s i n c e these models n e i t h e r i n c o r p o r a t e c o n s t r a i n t s nor permit i n c r e a s i n g r e t u r n s to s c a l e , there i s no innovation along the l i n e s o f the t h i r d type d i s c u s s e d . See Levin (16) f o r a d i s c u s s i o n o f t h i s type o f i n n o v a t i o n . The Nelson and Winter approach i s based on a l t e r n a t i v e c o e f f i c i e n t s generated by a random process (perhaps because b a s i c s c i e n t i f i c d i s c o v e r i e s are r a t h e r u n p r e d i c t a b l e ) and employs a m o d i f i e d p r o f i t a b i l i t y t e s t f o r t h e i r a d a p t a t i o n . Binswanger s t u d i e s the generation of a l t e r n a t i v e processes i n a d e t e r m i n i s t i c model i n which research expenditures may be a l l o c a t e d to change process c o e f f i c i e n t s i n a d e s i r e d d i r e c t i o n . The Nelson and Winter model assures the generation o f p o i n t s near e x i s t i n g p o i n t s by appropriate s p e c i f i c a t i o n o f the random process. I f the R&D cost of changing c o e f f i c i e n t s i n the Binswanger model generates r e l a t i v e l y s m a l l p e r i o d - t o - p e r i o d changes, the Nelson-Winter and Binswanger approaches would have very s i m i l a r e m p i r i c a l i m p l i cations. Kamien and Schwartz (7) have put f o r t h a v a r i e t y of models which permit the i n t r o d u c t i o n of innovations that e i t h e r cause increases i n output f o r the same inputs or expand input s u b s t i t u t i o n p o s s i b i l i t i e s . The r e t u r n s from research are d e t e r m i n i s t i c i n t h e i r models, and f a i r l y general R&D cost f u n c t i o n s may be used. An attempt to model search a c t i v i t y f o r improving production processes has been made by Roth (17) who d i s t i n g u i s h e s between i n v e s t i g a t i n g known processes and spending resources to l e a r n the p r o p e r t i e s of combinations of subprocesses not p r e v i o u s l y used. The e x i s t e n c e of s u b j e c t i v e p r o b a b i l i t y d i s t r i butions of r e t u r n s t o the v a r i o u s a c t i v i t i e s i s assumed. I t may be that engineering process data can provide i n f o r m a t i o n about the frequency d i s t r i b u t i o n of changes i n c o e f f i c i e n t s to be used i n a Nelson-Winter type model. Although these data may be h e l p f u l f o r e m p i r i c a l implementation of such induced i n n o v a t i o n models as those o f Binswanger and Kamien and Schwartz, the absence o f r e s e a r c h and development expenditure data on a low enough l e v e l of aggregation i s a s e r i o u s o b s t a c l e . Furthermore,


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much of the R&D spending occurs outside the f i r m or i n d u s t r y i n question. None of these approaches seem s u i t a b l e f o r modeling the development of new processes i n the engineering sense. What makes new processes e s p e c i a l l y d i f f i c u l t to d e a l with i s that they o f t e n r e q u i r e a considerable e f f o r t i n b a s i c science as w e l l as i n the overcoming of engineering problems. B a s i c science connotes an extremely r i s k y a c t i v i t y i n which payoffs are subject to high v a r i a n c e . Rosenberg (11), f o r example, p o i n t s out that g r e a t l y improved knowledge of medicine took many c e n t u r i e s to develop despite the continuous flow of resources devoted to medical problems during that p e r i o d . D e t a i l e d knowledge of a product will supply some a p r i o r i ideas about the p o r t i o n of input space t h a t could be f r u i t f u l l y i n v e s t i g a t e d , but t h i s degree of d e t a i l may be more than i s d e s i r a b l e f o r purposes of general economic modeling. For s e v e r a l of the i n n o v a t i o n types discussed above it i s r a t h e r s t r a i g h t f o r w a r d to determine the impacts of changes i n r e l a t i v e and absolute p r i c e s . I f all input p r i c e s were to i n crease p r o p o r t i o n a l l y , f o r example, the payoff to input-reducing innovation i n general would i n c r e a s e . Changes i n r e l a t i v e input p r i c e s would f a v o r innovations that permit s u b s t i t u t i o n against the r e l a t i v e l y higher p r i c e d inputs and a l s o stimulate the search f o r new processes that economize on those i n p u t s . Implications of t h i s nature f o l l o w from the models discussed e a r l i e r i n t h i s s e c t i o n . The e f f e c t of p r i c e changes on c a p a c i t y - i n c r e a s i n g innovations i s more d i f f i c u l t t o analyze: an i n c r e a s e i n capac i t y leads t o a lower average cost with constant input p r i c e s , but t h i s will be o f f s e t to some extent by the higher costs a s s o c i a t e d with a p r i c e i n c r e a s e i n the n o n l i n e a r inputs that constrained c a p a c i t y — g e n e r a l l y p l a n t and equipment. Thus, it i s not c l e a r what e f f e c t a r i s e i n the p r i c e of c a p i t a l goods will have on c a p a c i t y when such i n c r e a s e s r e q u i r e a d d i t i o n a l c a p i t a l goods; innovations that reduce c a p i t a l i n t e n s i t y may become more a t t r a c t i v e than those t h a t i n c r e a s e c a p a c i t y . The e f f e c t s of environmental and workplace r e g u l a t i o n s have not been e x p l i c i t l y i n c l u d e d w i t h i n t h i s innovation model. Nevertheless, a few t e n t a t i v e g e n e r a l i z a t i o n s might be o f f e r e d . Some processes may be so harmful t o the environment or worker s a f e t y and h e a l t h t h a t the development of a new process i s necessary if continued production of the product i s t o take place. In other cases it may be necessary to s u b s t i t u t e f o r an input which has d e l e t e r i o u s e f f e c t s on the environment or worker s a f e t y and h e a l t h ; f o r example, innovations designed to permit the use of f u e l s other than c o a l might be generated. Note that a change i n f u e l may not be a simple s u b s t i t u t i o n because chemical process technology i s h i g h l y i n t e g r a t e d . For example, the same hot air or steam may be used f o r d i f f e r e n t purposes as it c o o l s . Moreover, i n steam reforming of n a t u r a l gas, the same input i s used both as f u e l and feedstock, and purge gases are used as


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Regulation

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supplementary f u e l . In such cases an attempt to change any part of the process may r e q u i r e changes throughout. Process m o d i f i cations f o r c o n t r o l of r e g u l a t e d e f f l u e n t s may i n c r e a s e f i x e d and operating costs i n v a r i o u s ways and may thus stimulate a search f o r f a c t o r - s a v i n g innovations i n the absence of f a c t o r p r i c e changes. F i n a l l y , c a p a c i t y - i n c r e a s i n g innovations may be i n h i b i t e d if an environmental r e g u l a t i o n takes the form of l i m i t s on t o t a l p o l l u t a n t emissions a t a given s i t e . Of course, t h i s e f f e c t may be p a r t i a l l y o f f s e t by reductions i n input use o r s u b s t i t u t i o n s f o r the offending input. Issues i n the E m p i r i c a l Study of Innovation The use o f the above model as a framework f o r the study of the e f f e c t s of government r e g u l a t i o n and other f a c t o r s on i n novation has a number of i m p l i c a t i o n s f o r e m p i r i c a l s t u d i e s o f those e f f e c t s . In p a r t i c u l a r , process innovation can be most conveniently s t u d i e d i n an i n d u s t r y t h a t : 1) has produced an unchanging product; 2) has undertaken process change over a cons i d e r a b l e p e r i o d of time; 3) has made p u b l i c data on input coe f f i c i e n t s , c a p a c i t y , input p r i c e s , and output p r i c e s ; and A) has experienced a h i s t o r y of government r e g u l a t i o n . With t h i s i n f o r mation it should be p o s s i b l e to explore the r e l a t i o n s h i p between input c o e f f i c i e n t s and c a p a c i t y on the one hand, and p r i c e s of inputs and outputs and government r e g u l a t i o n on the other. S p e c i f i c a l l y , input c o e f f i c i e n t s and maximum p l a n t c a p a c i t y may be t r e a t e d as dependent v a r i a b l e s i n a m u l t i p l e r e g r e s s i o n a n a l y s i s with input p r i c e s , output p r i c e , cumulative c a p a c i t y , and other v a r i a b l e s as independent v a r i a b l e s . Input c o e f f i c i e n t s are of s p e c i a l i n t e r e s t because, as mentioned above, they d e s c r i b e the production technology. Although input c o e f f i c i e n t s may be defined a t v a r i o u s l e v e l s of aggregat i o n , the most u s e f u l c o e f f i c i e n t s f o r studying innovation are those that c h a r a c t e r i z e the i n d u s t r y ' s l e a d i n g commercial technology. Such c o e f f i c i e n t s will r e f l e c t innovative responses to changes i n input p r i c e s and government r e g u l a t i o n f a r more promptly than the average i n d u s t r y r a t i o s o f inputs to output because an i n d u s t r y g e n e r a l l y i n c l u d e s p l a n t s o f v a r i o u s ages; these embody technologies adapted f o r p r i c e s and r e g u l a t i o n s of e a r l i e r periods. C o e f f i c i e n t s f o r l e a d i n g technologies are a v a i l a b l e f o r many products i n the open l i t e r a t u r e . Several s t r a t e g i e s a r e a v a i l a b l e f o r estimating the e f f e c t s of government r e g u l a t i o n on input c o e f f i c i e n t s and c a p a c i t y . F i r s t , s i n c e a change to a new engineering process i s g e n e r a l l y w e l l documented and i s widely d i s c u s s e d , it should be r e l a t i v e l y s t r a i g h t f o r w a r d t o i d e n t i f y the r o l e , if any, o f r e g u l a t i o n i n causing the change. Input c o e f f i c i e n t data are l i k e l y t o be a v a i l a b l e f o r both o l d and new processes so that costs could be compared i n an attempt to i s o l a t e the r o l e of r e g u l a t i o n i n b r i n g i n g about the new process. Since the development of new



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processes i s extremely d i f f i c u l t to p r e d i c t , t h i s type of analys i s would not be very u s e f u l f o r f o r e c a s t i n g the engineering nature or d e t a i l s of responses to government r e g u l a t i o n . The types of innovation that take place w i t h i n a b a s i c process could be examined s t a t i s t i c a l l y . Separate r e l a t i o n s h i p s could be estimated f o r periods w i t h i n which r e g u l a t i o n s were unchanged, and t e s t s could be made f o r s i g n i f i c a n t d i f f e r e n c e s between subperiods when r e g u l a t i o n s do change. I f time periods of unchanging r e g u l a t i o n are too s h o r t , a set of dummy v a r i a b l e s r e p r e s e n t i n g r e g u l a t o r y modes might be i n c l u d e d . In a d d i t i o n , an e f f o r t should be made to determine the extent to which regul a t i o n s were enforced, and v a r i a b l e s r e p r e s e n t i n g the degree of enforcement should be i n c l u d e d i n the r e g r e s s i o n s . A p p l i c a t i o n to Ammonia

Production

The s y n t h e t i c anhydrous ammonia i n d u s t r y s a t i s f i e s s e v e r a l of the c r i t e r i a mentioned above. I t was one of the first chemi c a l products to be produced using modern techniques; i t s comp o s i t i o n has remained constant over the years; it has been produced with a v a r i e t y of processes; input c o e f f i c i e n t s and p r i c e s are a v a i l a b l e i n the open l i t e r a t u r e ; and parts of the production process r e q u i r e considerable a t t e n t i o n to workplace s a f e t y and h e a l t h and to p r o t e c t i o n of the environment. U n f o r t u n a t e l y — a t l e a s t f o r the purpose of studying the determinants of i n n o v a t i o n — a n i n t e n s i v e search of the l e g a l and t e c h n i c a l l i t e r a t u r e revealed t h a t ammonia production had not been s u b j e c t to r e s t r i c t i v e government r e g u l a t i o n over the r e l e vant time p e r i o d (JL). Instead, sound engineering and business p r a c t i c e s r e s u l t e d i n reasonable l e v e l s of workplace s a f e t y and environmental p r o t e c t i o n i n the absence of r e g u l a t i o n . Although recent trends suggest increased government a c t i v i t y i n t h i s i n d u s t r y , impacts on input c o e f f i c i e n t s have not yet appeared. E m p i r i c a l work was therefore r e s t r i c t e d to the e f f e c t s of input p r i c e s and cumulative gross c a p a c i t y on input c o e f f i c i e n t s and to the e f f e c t s of output p r i c e , l a b o r c o s t s , c a p i t a l c o s t s , and cumulative gross c a p a c i t y on the maximum c a p a c i t y of new p l a n t s . L i n e a r and l o g - l i n e a r equations were estimated. Input c o e f f i c i e n t data were obtained from engineering information r e l a t i n g to newest p l a n t s . A search of engineering j o u r n a l s and other p u b l i c a t i o n s uncovered numerous a r t i c l e s t h a t present input c o e f f i c i e n t s f o r the l a t e s t ammonia p l a n t s a v a i l a b l e at the time. These were adjusted to improve comparability among p l a n t s with respect to such items as which f a c i l i t i e s are i n c l u d e d i n i n v e s t ment and whether steam i s purchased or generated. A t t e n t i o n was confined to p l a n t s that produced ammonia by steam reforming of n a t u r a l gas. The p e r i o d s t u d i e d , 1947-1972, witnessed the switch from r e c i p r o c a t i n g to c e n t r i f u g a l compressors, which i n many respects may be regarded as a process i n n o v a t i o n . Data on p l a n t c a p a c i t y were estimated by compiling a h i s t o r y of U.S.


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Regulation

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ammonia production f a c i l i t i e s , and p r i c e data are a v a i l a b l e from government and i n d u s t r y p u b l i c a t i o n s . A d e t a i l e d d i s c u s s i o n of data, methods, and r e s u l t s may be found i n (1). The r e s u l t s from the input c o e f f i c i e n t regressions were encouraging. They suggest that increases i n the p r i c e s of n a t u r a l gas, e l e c t r i c i t y , and c a p i t a l r e s u l t i n a decreased use of the r e s p e c t i v e inputs with a l a g of 6 years. A l a g of t h i s length suggests that more than simple s u b s t i t u t i o n i s taking p l a c e . The estimated c o e f f i c i e n t of cumulative gross capacity implied that growth i n i n s t a l l e d c a p a c i t y reduced i n p u t s , but t h i s r e l a t i o n ship was not s t a t i s t i c a l l y s i g n i f i c a n t . Results with the c a p a c i t y equations were not as c l e a r - c u t . Although v a r i a b l e s a f f e c t e d c a p a c i t y i n the hypothesized d i r e c t i o n s , they were not g e n e r a l l y s t a t i s t i c a l l y s i g n i f i c a n t . One p o s s i b l e reason was the l a c k of a v a r i a b l e that measures t r a n s p o r t a t i o n c o s t s . Further research should attempt to r e c t i f y t h i s problem. Conclusions D e t a i l e d conclusions and p o l i c y i m p l i c a t i o n s may be found i n (1). Regarding the e f f e c t s of government r e g u l a t i o n on ammonia process technology, it was concluded t h a t : 1) recent workplace and environmental r e g u l a t i o n have not yet had a s i g n i f i c a n t impact on ammonia production, but some proposed r e g u l a t i o n s may do so; 2) r e g u l a t i o n s concerned with the s a f e t y of pressure v e s s e l s , which have been i n e f f e c t f o r many years at the s t a t e l e v e l , were c o n s i s t e n t with, and p o s s i b l y based on, standards devised by p r o f e s s i o n a l c o d e - s e t t i n g i n s t i t u t i o n s ; 3) c e r t a i n aspects of EPA s p o l i c i e s lead to end-of-pipe treatment of p o l l u t a n t s r a t h e r than in-process treatment; and 4) OSHA's m u l t i t i e r e d enforcement mechanism preserves some scope f o r process innovation. The m u l t i p l e r e g r e s s i o n a n a l y s i s demonstrated that process technology responded to f a c t o r p r i c e changes i n a manner cons i s t e n t with the hypothesis that innovations tend t o economize on r e l a t i v e l y expensive i n p u t s . I f t h i s phenomenon can be v e r i f i e d more g e n e r a l l y , policy-makers may have greater c o n f i dence i n the a b i l i t y of the economy to adjust dynamically to changed a v a i l a b i l i t y and p r i c e s of i n p u t s . The approach described i n t h i s paper can be a p p l i e d t o other i n d u s t r i e s . I t should be p o s s i b l e to i d e n t i f y chemicals that have been subject to government r e g u l a t i o n f o r which input c o e f f i c i e n t s over a reasonably long p e r i o d are a v a i l a b l e i n the open l i t e r a t u r e . The f i n d i n g t h a t process innovation can be explained by movements i n input p r i c e s should be subjected t o f u r t h e r t e s t i n g , and the study of other products may r e v e a l more c l e a r l y the r o l e of government r e g u l a t i o n s i n determining process i n n o v a t i o n s . 1


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REGULATION

AND CHEMICAL

INNOVATION

Acknowledgment F i n a n c i a l support was s u p p l i e d by the N a t i o n a l Science Foundation, Grant Number RDA 75-23266. Opinions and c o n c l u s i o n s are those of the author.

Literature Cited 1. Greenberg, E., Hill, C. T., Newburger, D. J., "Regulation, Market Prices, and Process Innovation: The Case of the Ammonia Industry" Westview Press, Boulder, 1979. 2. Schmookler, J., "Invention and Economic Growth" Harvard University Press, Cambridge, 1966. 3. Nordhaus, W. D., Amer. Econ. Rev. (1969), 59, 18. 4. Asher, Η., "Cost-Quantity Relationships in the Airframe Industry" RAND Corporation 12-291, Santa Monica, 1956. 5. Arrow, Κ., Rev. Econ. Stud. (1962), 29, 155. 6. Utterback, J. M., Abernathy, W. J., "A Test of a Conceptual Model Linking Stages in Firms' Process and Production Innova t i o n , " BH5 74-23, Graduate School of Business Administration, Harvard University, Boston, November 1974. 7. Kamien, M. I., Schwartz, N. L., Econometrica (1967), 36, 1. 8. Nelson, R. R., Winter, S. G., Amer. Econ. Rev. (1975), 65, 338. 9. Binswanger, H. P., Econ. J. (1974), 84, 940. 10. Kamien, M. I., Schwartz, N. L., J. Econ. Lit. (1975), 13, 1. 11. Rosenberg, Ν . , Econ. J. (1974), 84, 90. 12. Moore, F. T . , Quart. J. Econ. (1959), 73, 232. 13. Chenery, H. B., Quart. J. Econ. (1949), 63, 307. 14. T e i t e l , S., J. Common Market Studies (1975), 13, 92. 15. Myers, J. G., Nakamura, L., "Energy and Pollution Effects on Productivity: Putty-Clay Approach," National Bureau of Econmmic Research, N.Y., 1976 (Mimeo). 16. Levin, R. C., "Technical Change, Economies of Scale, and Market Structure" Yale University, New Haven, 1974 (Ph.D. dissertation). 17. Roth, T. P., Engineering Economist (1972), 17, 249. RECEIVED

March 8,

1979.


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