Market structure and innovation: explaining differences between actors

Key findings

 The market structure can help in understanding different levels, speeds and types of innovation across the diverse sub-sectors of transport. This heterogeneity is a key barrier to innovation in the transport sector as it creates complexity for innovations that require collaboration between different players (e.g. vehicle/fuel/infrastructure).

 The level of competition can be linked to the propensity to innovate. Very high competition levels act as a disincentive to innovations. This is particularly true when the service provided is homogenous across the competitors and price is therefore the main criterion, while the costs of innovation are high. Also monopoly rights may imply that companies are not motivated to invest in innovations. Medium competition levels and products that differ also through their features and not only through the price create a framework that is beneficial to innovations.

 The market size is another important element in understanding which modes are most likely to be leading innovation, since larger markets (e.g. passenger cars) allow for a more widespread amortization of the investments required for innovation in comparison with smaller ones (e.g.

ships).

 Linked to this, the turnover of assets and the costs of innovation also influence the propensity to innovate. In general, capital-intensive innovation in assets with a long product cycle may act as a disincentive to innovation as the return on investment stretch over a very long period.

 Among all transport sectors, the automotive sector – and here within particularly the manufacturers of passenger cars and associated suppliers – has an elevated genuine incentive to innovate due to their market structure and the heterogeneous nature of the product. In line with this, more than 60% of all companies active in this sector are considered active in innovation.

 In aviation, R&D intensities are very elevated due to the importance of safety and security requirements. Moreover, civil and military aeronautics are strongly interlinked, enabling the civil industry to benefit from defence-funded research.

 Providers of transport services are exposed to a high price pressure and limited market entry barriers. They sell homogenous goods, for which the price and not innovation is the key selling factor. Hence, the turnover created by the sale of new product remains small. This explains the comparable low number of innovative companies in this segment when compared to the manufacturers of transport equipment.

 The theoretical considerations are supported by the R&D intensities of the different actors.

Moreover, the share of innovative products in the total turnover of the various transport sub-sectors clearly underlines the importance of innovation output to the manufacturing industries, whereas innovation contributes little to the turnover of transport service providers.

Policy conclusions

 There may be less need to stimulate additional corporate R&D in the transport manufacturing sectors in general, and in particular the automotive and aviation sector, and ITS compared to other sub-sectors of transport.

 On the contrary, actors offering transport services and constructing and maintaining the transport infrastructure have little incentive to innovate. They may therefore require direct R&D support and more incentives to innovate, in particular when considering that they may push forwards systemic, cross-modal innovations.

Innovation can lead to a competitive advantage, but with increasing competition, the expected future profits decrease until the firm innovates further. Hence, neither perfect competition nor monopolies are optimal in terms of delivering innovation. Aghion et al. (2005) found that the relationship between product market competition and innovation takes the shape of an inverted U (see Figure 12).

Following (ITF, 2010b), this relationship can help in better understanding the incentives for innovation of the various, heterogeneous subsectors subsumed under transport.

Figure 12: Market structure and innovation effort Source: ITF (2010b)

Besides the competition level, other factors that influence the propensity to innovate are the nature of the good, the turnover time and the market sizes. In particular, heterogenous goods in which innovation may be a 'selling factor' will trigger more innovation efforts than goods that compete merely over the price, even though process innovations are also important in the latter case in order to reduce production costs. Long turnover times and a small market size tend to be adverse to innovation as they result in a lower demand for (novel) products and hence potentially longer payback times for the innovators. Finally, the capital intensiveness of the innovation is likely to affect the innovation propensity.

In general, these market conditions can help in explaining the incentive of the various transport modes in innovating. At the same time, however, particularities of some sectors, in particular the interlinkage with defence-driven innovation efforts, need to be taken into account. Other relevant factors are the technological opportunities faced by firms acting in different sub-sectors and the technological capability of firms that are embedded in their labour force, since skilled employees are a key asset for an innovative firm.

For most of the providers of transport services, and here in particular for goods (trucking, postal service, etc.), competition levels are very high. Low entry and exit barriers result in many small firms operating at small margins, resulting in limited capacity to cover fixed costs and finance innovation (ITF, 2010b). Moreover, transport service providers sell a homogenous good that differs mainly through price, implying that innovative products contributing only very limited to the total turnover of the sector (less than 15%; see Figure 5). The resulting price pressure, high levels of competition and the homogenous nature of the product means that transport companies focus largely on reducing their costs, and act as a disincentive to invest in innovations. This is confirmed by the fact that less than 40% of the companies active in the sector 'Transportation and storage' are considered to be innovative firms (Figure 13). In line with this are the very low levels of R&D investments and of the R&D intensity (0.3%) found in the quantitative analysis for the ICB class ' Industrial transportation' (section 5.2). Some segments of public transport lie on the other extreme and are exposed to rather limited competition (ITF, 2010b). Also this near-monopolistic situation acts as a disincentive to innovation.

Hence, most of the actors that could push for cross-modal innovations have low research activities.

The automotive sector, on the contrary, may be described as a monopolistically competitive industry.

Unlike other transport sectors that offer a mainly homogenous service, the automotive industry aims to differentiate their products between competitors. Innovative products serve as one criterion for this branding and may ultimately be one of the 'selling factors' of vehicles, as users are not only price sensitive but also performance sensitive. In consequence, innovative products contribute significantly

to the turnover of the industry, accounting for almost half of the total as shown in Figure 5. At the same time, however, the automotive industry needs to reduce costs and increase productivity. If appropriate, it may also decide to opt for a fast introduction of innovations while leveraging on larger markets to recover costs. Process innovations are crucial for aligning these counteracting objectives one with another. The idea of a platform strategy to be used by many different models and the development of engine families to be used by different brands of the same group illustrate this point.

All in all, innovation in the automotive sector is characterised by a strong focus on the core competencies and the constant interplay of product and process innovation (Rhys, 2005; quoted in Sofka et al., 2008). This is confirmed by the results of the Community Innovation Survey (CIS 2008), which demonstrates that for manufacturers of motor vehicles and of other transport equipment, innovation is driven both by the motivation to increase the range and quality of goods and by reducing the labour costs per unit of output.

Thus, the automotive sector has a high incentive for innovating. This is supported by the findings of the quantitative assessment undertaken within the present study, according to which car manufacturers had an R&D intensity of more than 5% in 2008¹⁰. Considering that major parts of the innovation take place in large tier-1 suppliers (but also smaller tier 2 to tier 4 providers, see chapter 9.4), it is not surprising that the automotive suppliers show an R&D intensity that lies even above this (6%; see Figure 19). In line with this, the results of the CIS-survey indicate that of all transport-related sectors, the share of innovative companies is most elevated for manufacture of motor vehicles, trailers and semi-trailers (more than 60%; Figure 13).

However, the high competition pressures in some countries (e.g. the UK and Germany) may mean that the incentives for innovation already create a disincentive (Sofka et al., 2008). It is difficult to estimate which effect the economic downturn will ultimately have on innovation. On the one hand, it further reduces profit margins and lowers demand of cars, hence increasing competition levels. Moreover, with the advent of novel technologies such as electric vehicles, newcomers beyond traditional manufacturers have entered the market. On the other, the consolidation process has been accelerated with significant M&A activities and cooperation agreements between car manufacturers.

Manufacturer of commercial vehicles are exposed to a higher level of competition than car manufacturers as transport companies will follow a strict economic calculus when buying new equipment and are not ready to pay for 'innovative technologies' as such. In parallel, they are also exposed to a smaller and more volatile market base (the commercial vehicle market is especially sensitive to changes of the economic growth rate). Innovations performed by manufacturers of commercial vehicle are also likely to largely focus on fuel efficiency in order to bring down the total operating cost for commercial vehicles. This explains why innovation activities are lower than those of the automotive industry, with an R&D intensity of 3.5%.

Competition levels in the aviation industry are elevated (Hollanders et al., 2008), even if the number of major players worldwide is limited and concentrates largely on EU and US-based companies.

Considering the outstanding safety and security requirements of this sector as well as the extreme relevance of fuel cost reductions for the airline revenues (resulting in a strong incentive for increased efficiency), it can be considered as research intensive. In principle similar to the automotive industry, yet probably to a lesser extent, innovation constitutes a selling factor for the aviation production industry. The high interlinkage and mutual knowledge flows between civil and military aircraft developments is another important characteristic of this sector. Figure 5 shows that innovative products deliver almost one third of the total turnover of the manufacturers of other transport equipments, which include aviation. These factors explain the elevated R&D intensity of the EU aviation industry, reaching 7.8% in civil aeronautics (see Figure 19).

In the rail supply industry, competition is elevated despite the rather limited number of players and the relatively small market size, in comparison with road modes. The European rail supply industry is amongst the main players on the world scale (European Commission, 2009c) with an R&D intensity

10 Note that R&D expenditures or activities are often used as a proxy for innovation, which is not necessarily the case.

Furthermore, a reduction in R&D expenditures may also include an abolishment of inefficiently high or ill-directed expenditures (European Commission, 2006b).

estimated to be 3.9%. It is worth mentioning that the actual innovation in the rail industry may to be more intense than reflected by the figures, as the sector partly benefits from research in other areas.

The waterborne sector in the EU is limited to specialist products and military production mainly;

production of low-value vessels is often undertaken outside of the EU. Its R&D intensity is found to be 3.2% (1.6% for shipyards and 4.1% for manufacturers of equipment). This may be influenced by the relatively limited opportunities for the recovery of investments targeting innovations due to a relatively small market base, in comparison with other modes. Especially for the EU-based ship-building industry, which is world leader in the export of military vessels (European Commission, 2009c), the knowledge transfer from military innovations may be considered an important driver for innovations. Compared to maritime shipping, inland waterways works under different operating conditions (e.g. vessel dimensions are determined by the fairway), and vessels have longer lifetimes.

The construction sector is exposed to a high level of competition, in particular for small contractors.

In parallel, competition among large general contractors and among specialty firms has been identified as oligopolistic (OECD, 2008), and anecdotic evidence from discussions with multinational construction companies illustrate that they not often compete for the same projects among each other, even if the lack of a strong competitive environment is less pronounced in Europe and the United States (Girmscheid and Brockmann, 2006). The limited degree of competition seems to be especially important in the case of large and capital intensive applications, typically characterising the large transport-related infrastructures. Albeit different, these indications concur in the identification of a rather poor performance of the construction with respect to innovation, as confirmed by its low R&D intensity (0.3%).

The ITS sector cannot directly be compared to other transport sectors, in particular as it is strongly interlinked with other transport sub-sectors (e.g. car manufacturers dedicate significant parts of their R&D investments to ITS and other infotainment) and therefore exposed to their market conditions, and because important parts of the ITS developments take place outside of the core transport sector.

Despite this, ITS can be characterised as a technological area that combines very fast turnover times with relatively low capital intensiveness of the product, and for which innovative features constitute one selling factor. These are strong indications of the sector being research-intense, which is fully in line with the elevated R&D intensity observed (6.4%).

0%

Figure 13: Share of innovative companies in various transport-related sectors Data source: Eurostat CIS survey 2008 (based on NACE R2 sectors; retrieved in January 2011)

3 Barriers to innovation in the transport sector and ways