Quality Ladders, Competition and Endogenous Growth

We examine a theory of competitive innovation in which new ideas are introduced only when diminishing returns to the use of existing ideas sets in. After an idea is introduced, the knowledge capital associated with that idea expands, and its value falls. Once the value falls far enough, it becomes profitable to introduce a new idea. The resulting theory is consistent with fixed costs of innovation and it accounts for the same facts as existing theories of endogenous growth. However, there is evidence that innovation frequently takes place even absent monopoly power and that it is driven by diminishing returns on existing ideas – two facts that the existing theory cannot account for. 1 We are indebted to years of discussion with Chad Jones, Larry Jones, Robert E. Lucas, Joseph Ostroy, Paul Romer, and James A. Schmitz about these issues. Pete Klenow, Rafael Repullo and Nancy Stokey also made many useful comments on this paper. We are especially grateful to Alexandre Monge-Naranjo for a masterful discussion in New York, which we have used extensively. Thanks to the National Science Foundation, Grant No. SES-03-14713, and the Spanish MES, Grants No. SEJ 2005-08783-C04-01 and ECO2008-06395-C05-01, for financial support.