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Working paper

Destabilizing Effects of Market Size in the Dynamics of Innovation

Matsuyama K., Ushchev P.
In existing models of endogenous innovation cycles, market size alters the amplitude of fluctuations without changing the nature of fluctuations. This is due to the ubiquitous assumption of CES homothetic demand system, implying that monopolistically competitive firms sell their products at an exogenous markup rate in spite of the empirical evidence for the procompetitive effect of entry and market size. We extend a model of endogenous innovation cycles to allow for the procompetitive effect, using a more general homothetic demand system, which contains both CES and translog as special cases. We show that a larger market size and/or a smaller innovation cost, which causes the markup rate to decline through the procompetitive effect, has destabilizing effects on the dynamics of innovation.