Income, Endogenous Market Structure, and Innovation

We investigate the effect of income distribution on R&D in a dynamic framework. Our model captures both the infinite R&D race among heterogeneous innovators and a market where successful innovators generate revenues. The market structure of successful innovations is endogenous – firms produce vertically differentiated substitute goods and compete in price. Based on firms' equilibrium market revenues, we derive numerical solutions of the Markov perfect equilibrium innovation rate of the dynamic problem. A key insight in our results is that explicitly modeling price competition and the market structure plays an important role in evaluating the impact of rising income inequality on R&D; furthermore, the way aggregate innovation responds to regulatory policies might also depend on the market structure. Contrary to past findings, we show that increasing income inequality has a negative effect on innovation when the market quality gap is large, in which case, price competition leads to lower revenues and diminishes the innovation incentives. Regarding R&D policies, subsidies are found to dampen the innovation efforts; however, under certain market structure conditions, they also encourage entry to the R&D race. Tax incentives that reduce the variable R&D costs are shown to have positive effects on innovation