Firms in product space: a new look at the economics of innovation and supply


Firms in product space: a new look at the economics of innovation and supply

By John Morrow, Luca Macedoni and Vladimir Tyazhelnikov

In a world driven by demand and innovation, several important questions arise: How can we predict which products are likely to be produced next and by whom? How can a firm decide whether they should produce a new product line? How can policymakers foster more innovation in new products? And how might consumers benefit from new products being introduced?

These questions are not just theoretical; they have real-world implications, impacting everything from green technologies to emergency supplies.

A new ESCoE discussion paper from Luca Macedoni, John Morrow and Vladimir Tyazhelnikov takes a new look at the economics of innovation and supply.

Mapping product space

Imagine a map, where each product a company might produce is a point in space. The closer a firm is to a product on this map, the lower the potential costs and the higher the likelihood they will start producing it. This concept is a more complex version of finding a phone user’s location based on their proximity to cell towers. Our discussion paper develops an innovative method to construct this product space.

How we did it

Using product production patterns within and across firms, we mapped a cost-based distance between businesses and unproduced products.

Our method uses production data from Danish firms, from 2000-2018. However, this can be extended to any EU firm.  

Firstly, we estimated the distance between any two product pairs. Then, we located products in the product space and, finally, we located firms in the space.

We introduced two key measures: Revenue Potential (RP) and Competition Potential (CP). Revenue Potential is the potential of a revenue source to generate revenue and helps predict both sales and scope to develop a more diverse product portfolio. Competition Potential measures potential losses from competitors producing similar products. It calculates how a firm’s revenue would fall if all potential rivals were to compete within its existing markets. It predicts whether a firm will view it worthwhile to increase sales or the diversity of its product portfolio.

What did we find?

Our findings reveal that the “distance” between a firm and a product can accurately predict whether the firm will adopt the product over time or when there are demand shocks. This considers various factors that traditional classification systems might miss.  

The paper also shows the potential benefits to consumers when firms enter new product markets. The potential gains are significant, ranging from 10-30% increased consumer welfare across different sectors.

Why does it matter?

For businesses

The implications of this research for businesses are profound. For one, it uncovers the latent potential within firms to diversify their product lines, particularly those positioned close to unproduced products in the product space. This proximity could signal significant growth opportunities.

Looking at Revenue Potential also shows how much a firm could expand its revenue by tapping into accessible products within this space.

But it’s not all smooth sailing. The exploration of Competition Potential reminds us that challenge may come with opportunity. A firm may seem poised for rapid expansion, but a dense cluster of potential competitors could limit its growth and portfolio diversification.

For policymakers and wider society

Along with increasing understanding of product development and firm strategy, this research offers a beacon for policymaking. By identifying which firms are likely to produce critical or innovative products, policies can be tailored to support these potential market entrants. This can catalyse the introduction of beneficial products to society.

The research also shows the consumer benefits of fostering a competitive, innovative market landscape.

This new classification of a continuous, cost-based product space presents new opportunities. For firms, it’s a call to venture closer to the uncharted territories of their respective product space. For policymakers, it’s an invitation to craft informed, effective strategies that harness the latent potential within the market. And for society at large, it’s a potential tool for private-public partnerships to spur entry into new products and markets.

John Morrow is a Research Associate at ESCoE and Reader in Economics at King’s Business School. He is also an Associate with the Centre for Economic Performance and CEPR. This blog was co-authored by Luca Macedoni and Vladimir Tyazhelnikov.

ESCoE blogs are published to further debate.  Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the ESCoE, its partner institutions or the Office for National Statistics.

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