Reconsidering the Market Size Effect in Innovation and Growth

Abstract

In the standard horizontal innovation model of endogenous growth, larger economies innovate more and grow faster. Due to the homotheticity of preferences, however, it does not matter whether the large market size comes from a large population or a high per capita expenditure. In this paper, we extend the standard model to allow for nonhomothetic preferences. Among others, we show that, holding the size fixed, economies with higher per capita expenditure and smaller populations innovate more and grow faster for the empirically relevant case of incomplete pass-through, strategic complementarity in pricing, and procompetitive entry.

Keywords: endogenous growth, balanced growth, horizontal innovation, nonhomothetic preferences, directly explicitly additive (DEA) preferences, demand composition, incomplete pass-through, strategic complementarity in pricing, procompetitive entry, competition and growth

JEL Classification: O11, O31, O33