Bigger Is Better: Market Size, Demand Elasticity, and Innovation*

Abstract

This article proposes a novel mechanism whereby larger markets increase competition and facilitate process innovation. Larger markets, in the sense of more people or more open trade, support a larger variety of goods, resulting in a more crowded product space. This raises the price elasticity of demand and lowers markups. Firms, therefore, become larger to break even. This facilitates process innovation, as larger firms can amortize R&D costs over more goods. We demonstrate this mechanism in a standard model of process and product innovation. In doing so, we question some important results in the new trade and endogenous growth literatures.

The Evolution of Markets and the Revolution of Industry: A Unified Theory of Growth

“…2 As goods '…ll up this circle', neighboring varieties become closer substitutes, implying a higher price elasticity of demand and a lower mark-up (Helpman andKrugman, 1985, Hummels andLugovskyy, 2005). As shown by Desmet and Parente (2010) in a static one-sector model, these preferences imply a positive e¤ect of market size on technological innovation.…”

“…Therefore, in as far as we match the size of …rms and the number of workers in the industrial sector, we are also matching what corresponds to the number of varieties in our model. 20 Whereas the intuition for the model's take-o¤ and limiting properties are clear, the transitional dynamics require some further discussion. The de…ning feature of the industrial revolution is the acceleration in the innovation rate.…”

The Role of Two Frictions in Geographic Price Dispersion: When Market Friction Meets Nominal Rigidity

“…In this case, the persistence of the relative price,  is equal to the persistence of productivity, and the (conditional) volatility of  is increasing in  and    If   0 the persistence is given by ( +   )  (1 +   ) which is increasing in  but is independent of  The (conditional) volatility is increasing in  but is decreasing in . So, the Calvo 17 See Appendix B for the detailed model setup and solutions. 18 Here we drop the good index for notational convenience.…”

Why Did the Industrial Revolution Start in Britain?

“…And Smith strongly believed that the specialization -and so the division of labor -was one of the most important channels through which technological change occurred, thus joining many other scholars' view that the market size is a crucial determinant of innovation (see e.g. Sokoloff, 1988;North, 1990, Engerman and Sokoloff, 1997, Khan and Sokoloff, 2001, Sokoloff and khan, 1990Desmet and Parente, 2010. In addition to providing large markets for better and cheaper goods, the cities would also have contributed to developing different institutions such as the public services and the intellectual property rights (see e.g.…”

“…Galor and Weil, 2000), the market size (see e.g. Desmet and Parente, 2010), the stock of useful knowledge see (e.g. O'Rourke et al, 2013), or the evolution of individuals characteristics through natural selection (see e.g.…”