Up and down the quality ladder: A macroeconomic model of innovation and growth under demand-side inequality

Abstract: I study an economic growth model with non-homothetic preferences and demand-side inequality that induces innovation along three dimensions: Firms undertake product innovation to enter the market, they improve upon the production process of existing products, or they upgrade their quality. Departing from models of homothetic prefer- ences, process and quality innovation are no longer isomorphic choices for firms, and the demand side dictates incentives to innovate. If economic growth is mainly driven by quality or process innovation, a lower income gap between rich and poor consumers encourages growth while a higher income concentration has an ambiguous effect. If the economy relies on product innovation, a higher income gap has positive effects. Finally, the model accounts for a set of empirical regularities: (i) many products are initially only affordable to affluent consumers, (ii) product cycles are characterized by decreasing prices, (iii) the variety of products is expanding in a firm's lifetime, and (iv) the average quality of products increases over time.