Innovation in Space

Why do private firms invest in innovation? Surely the answer to this question is related to the benefits that firms obtain from improving their technology or production processes. In particular, the rate of innovation has been traditionally linked to the capacity of firms to generate profits from these innovations. These profits, in turn, are used by firms to finance their investments in technology. In fact, this logic has been used in the economic growth literature to justify the presence of imperfect competition and monopoly power. How can firms finance their innovations if perfect competition eliminates all their profits? In this short paper we discuss a mechanism that can lead to private innovation by firms even in the presence of perfect competition (see Desmet and Rossi-Hansberg, 2011a, where we introduced this logic to analyze development over space). The key elements are the presence of non-replicable factors of production that are essential for the production process and innovations that are to a degree specific to these factors. In the presence of these non-replicable factors, perfect competition in the product market, together with competition in the inputs markets, can lead to optimal innovation (absent intertemporal externalities). That is, the presence of these non-replicable factors leads to optimal innovation even in the absence of any market power by firms. The main example of such a non-replicable factor is land. Locations are given and cannot be reproduced. Even if other land is available in nearby locations, that land is not identical in that it is located somewhere else. A store on Fifth Avenue in New York or the Magnificent Mile in Chicago is quite a different business from a store in one of their side streets.