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Technological change and creative destruction

Trace how an innovation lowers costs, changes market structure and drives out older firms

Technological change starts as an invention and reaches the market as an innovation

Technological change combines two steps. Invention is an advance in knowledge: a new idea, design or discovery. Innovation is putting that advance to use in a new product or service, or in a new way of producing. An invention can sit unused for years, and only the innovation changes what firms sell or how they make it.

A new process lowers costs and shifts the cost curve down

A firm looks for the method that makes its output at the lowest cost, because lower costs raise profit and because a rival that finds a cheaper method can undercut it. A new process that needs fewer inputs for each unit lowers the average cost of every level of output, so the average cost curve shifts down from AC1 to AC2. The firm can keep its price and earn more on each unit, or cut its price and take customers from rivals still using the old method.

A new process lowers average costVertical axis: Cost per unit. Horizontal axis: Output. AC1: a downward-sloping curve. AC2: a downward-sloping curve. A point at C1 on the vertical axis and Q1 on the horizontal axis. A point at C2 on the vertical axis.Q1C1C2AC1AC2
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Old methodWith the old method, making Q1 costs C1 per unit on AC1.

Output Q1 cost C1 per unit with the old method and costs C2 with the new one.