Innovation and Competition on a Rugged Technological Landscape

We develop a model of spatial competition in which the quality of a product is learned only after it is introduced to the market. Firms enter the market sequentially, deciding whether to locate on the frontier, outside the scope of the existing market, or whether to settle in a niche, between existing products. The uncertainty about the quality of the new product depends on this choice and is increasing in the degree of horizontal differentiation from existing products. We show that the need to innovate leads to cycles between frontier and niche innovation, and to narrower markets with less differentiation than in an environment of certainty. We characterize the rich and varied dynamics possible across markets, showing when and why innovation stops and a market stagnates, and provide insight into the life-cycle of innovative products, the form and likelihood of disruption, and other features of innovation. We propose a targeted policy intervention that, by encouraging innovation at a particular margin, reignites innovation in a stagnant market and generates a high return-on-investment.