rate of return arose from the prospect of lower production costs through process innovation.

Consider this example: Computer-based inventory control systems, such as those pioneered by Wal-Mart, enabled innovators to reduce the number of people keeping track of inventories and placing reorders of sold goods. They also enabled firms to keep goods arriving just in time, reducing the cost of storing inventories. The consequence? Significant increases in sales per worker, declines in average total cost, and increased profit. (Key Question 8)


Our analysis of product and process innovation explains how technological advance enhances a firm's profit, but it also hints at a potential imitation problem: a firm's rivals may be able to imitate the new product or process, greatly reducing the originator's profit from its R&D effort. As just one example, in the 1980s North American auto firms took apart Japanese Honda Accords, piece by piece, to discover the secrets of their high quality. This reverse engineering—which ironically was perfected earlier by the Japanese—helped the U.S. firms to incorporate innovative features into their own cars. This type of imitation is perfectly legitimate and fully anticipated; it is often the main path to widespread diffusion of an innovation.

In fact, a dominant firm that is making large profits from its existing products may let smaller firms in the industry incur the high costs of product innovation while it closely monitors their successes and failures. The dominant firm then

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