Income inequalities and innovation by incumbents

Our paper presents a new rationale for innovation by incumbents. We show that the possibility to price-discriminate between consumers having different levels of wealth is a sufficient incentive for the industry leader to overcome the Arrow (1962) effect and keep investing in R&D, even in the absence of any incumbent advantage in the R&D field. We model an economy composed of two distinct groups of consumers, differing in their wealth endowment and subject to non-homothetic preferences, obtained through unit consumption of the quality good. We demonstrate that in such a framework, there exists a unique steady state equilibrium with positive innovation rates of both incumbents and challengers. Beyond its novelty, this result then also allows us to analyze the effect of the extent of income inequalities on both the challenger and incumbent innovation rates, and by extension on the economic growth rate. We demonstrate that a higher share of the population being poor is detrimental to the rate of economic growth, while a redistribution of wealth from rich to poor consumers increases the challenger innovation rate and has ambiguous effects on the incumbent’s investment in R&D.