Competition , Innovation , and Aggregate Fluctuations ∗

In this paper I study the link between innovation efforts, competition, and aggregate uncertainty. A productive sector consists in a continuum of duopolies that face a stochastic aggregate demand. In each industry the two firms choose their level of innovation through intertemporal optimization given their respective market power in the business. Since competition in the model lessens ex ante profits for tied firms as well as ex post margins for leaders, this structure engenders an invertedU relationship between competition and aggregate innovation. Then I investigate the quantitative implications of embedding this non monotonic link within a stochastic Markov perfect equilibrium framework. More precisely, the main focus of attention is on the impact of volatility on both the level and the cyclicality of innovation. Numerical simulations suggest that the inverted-U shape emerges in the presence of aggregate stochastic shock. Moreover, volatility has in this model a depressing effect on overall innovation.