Technological Progress, Downsizing and Unemployment

This paper presents a model where the form of innovations is endogenous. It is shown that with labour market imperfections, which raise the wage above the shadow price of labour, firms over‐invest in innovations cutting labour costs and under‐invest in increasing quality. As a result, the market outcome features lower long run growth, higher unemployment and lower welfare than the social optimum. It is further shown that a firm's incentives to cut labour costs are increased as wages rise and as the firm declines. Finally, a rise in competition increases incentives to downsize for firms with below average quality performance.