DP15010 Destabilizing Effects of Market Size in the Dynamics of Innovation

Author(s): Kiminori Matsuyama, Philip Ushchev
Publication Date: July 2020
Keyword(s): Dynamic monopolistic competition, Endogenous innovation cycles, H.S.A., market size, Periodic cycle, Piecewise-linear dynamical system, Procompetitive Effect, Robust chaotic attractor, the Judd model
JEL(s): D43, E32, L13, O31
Programme Areas: Industrial Organization, Monetary Economics and Fluctuations, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15010

In existing models of endogenous innovation cycles, market size alters the amplitude of fluctuations without changing the nature of fluctuations. This is due to the ubiquitous assumption of CES homothetic demand system, implying that monopolistically competitive firms sell their products at an exogenous markup rate in spite of the empirical evidence for the procompetitive effect of entry and market size. We extend a model of endogenous innovation cycles to allow for the procompetitive effect, using a more general homothetic demand system, which contains both CES and translog as special cases. We show that a larger market size and/or a smaller innovation cost, which causes the markup rate to decline through the procompetitive effect, has destabilizing effects on the dynamics of innovation.