On the Direction of Innovation

Research on the efficiency of innovation markets is usually concerned on whether the level of R&D firm investment is socially optimal. Instead, this paper studies whether R&D resources are employed optimally across research areas. Under weak assumptions, we find that competitive equilibrium innovative efforts are biased excessively into high returns areas. This form of market inefficiency is a novel result, and would take place even if innovators' profits coincided with the social value of innovations. We first demonstrate it in a simple, fundamental model. Then we embed our analysis in a canonical dynamic framework directly comparable with extant R&D models, and precisely identify the features of R&D competition that lead to the market failure we identify.