A Theory of Innovation and Its Effects

The theory of optimal sequential search is used to study an industry where firms make homogeneous products and seek lower costs of production. Research outlays correspond to the cost of search. The research results are regarded as drawings from a probability distribution that depends on the research outlays. Eventually, the production costs are so low, continuing the research no longer pays, the research era ends, and the mature era begins. Sequential research results in a cost level at the end of the research era and beginning of the mature era that is lower, the smaller the number of firms then in the industry. Firm market share and rate of return are positively related. The firm with the largest share during the research era retains its lead throughout, and its share tends to fall at a rate that is slower, the larger its share initially.