Rethinking Directed Technical Change with Endogenous Market Structure

I consider directed technical change in an economy where market structure is endogenous. Endogeneity of market structure leads to both theoretical and empirical implications that are substantially different from those in the existing literature and that in some cases are rather surprising. There are two dimensions of directed technical change: directed firm entry (new firms enter the industry with higher returns) and directed in-house research and development (R&D is higher in the industry with higher returns.). Directed firm entry responds to the industry market size effect and the price effect as in the existing literature. In sharp contrast to the existing literature, directed R&D depends on firm rather than industry market size. Furthermore, the firm’s market size is endogenous, and its response to economic conditions affect several results on the behavior of directed technical change. The endogeneity of firm size has generally been ignored in the previous literature. Directed technical change alters the relative demands for factors of production and leads to a change in relative factor returns. Directed firm entry changes relative factor returns through a social return to variety (an externality), and directed R&D changes relative factor returns through changes in relative factor productivities. Empirically, the second channel is the main force shaping relative factor productivities and hence relative factor returns. The model also includes fixed operating cost, which turns out to be important for the direction of R&D and for the existence of balanced growth path (BGP) for the economy. The model provides a complete solution for the economy’s transition dynamics as well as its balanced growth path.