We attempt to understand potential common forces behind rising market concentration and a slowdown in business dynamism in the US economy, through a micro-founded general equilibrium model of endogenous firm dynamics. The model captures the strategic behavior between competing firms, its effect on their innovation decisions, and the resulting “best-versus-the-rest” dynamics.

We consider multiple potential mechanisms that can drive the observed changes and use the calibrated model to assess their relative importance, with particular attention to the implied transitional dynamics.

We present new evidence that corroborates a declining knowledge diffusion in the economy.

…Similar to these studies, our theoretical framework centers on an economy that consists of many sectors. In each sector, two incumbent firms, which can also be interpreted as “the best” and “the rest”, produce imperfect substitutes of the same good with different productivity levels and compete à la Bertrand for market leadership. This competitive structure gives the market leader—the technologically more advanced firm—a pricing advantage in proportion to its technology lead over its rival; hence, the markups evolve endogenously as a function of the technology gap between firms. Market leaders try to innovate in order to open up the lead and increase their markups and profits. Follower firms try to innovate with the hope of eventually leapfrogging the market leader and gaining market power. Likewise, new firms attempt to enter the economy with the hope of becoming a market leader someday. A very important aspect of the model is the strategic innovation investment by the firms: intense competition among firms, especially when the competitors are in a neck-and-neck position in terms of their productivity levels, induces more aggressive innovation investment and more business dynamism. Yet when the leaders open up their technological lead, followers lose their hope of leapfrogging the leader and lower their innovation effort. Likewise, entrants get discouraged when the markets are overwhelmingly dominated by the market leader, and the entry rate decreases.

…Reduction in knowledge diffusion is able to account for these trends as follows. When knowledge diffusion slows over time, as a direct effect market leaders are shielded from being copied, which helps them establish stronger market power. When market leaders have a bigger lead over their rivals, the followers get discouraged; hence, they slow. The productivity gap between leaders and followers opens up. The first implication of this widening is that market composition shifts to more concentrated sectors. Second, limit pricing allows stronger leaders (leaders farther ahead) to charge higher markups, which also increases the profit share and decreases the labor share of GDP. Since entrants are forward looking, they observe the strengthening of incumbents and get discouraged; therefore, entry goes down. Discouraged followers and entrants lower the competitive pressure on the market leader: when they face less threat, market leaders relax and experiment less. Hence, overall dynamism and experimentation in the economy decrease.

…As a cautious remark, our results do not mean, and are far from implying, that the decline in knowledge diffusion is the only driver of the observed trends. Indeed, each empirical trend might have its own leading factors, and those factors may be different from the ones studied here. However, our analysis instead shows that among the mechanisms we consider—changes in corporate taxation, government support for incumbents, increased cost of entry, and reduced knowledge diffusion (potentially due to anticompetitive use of intellectual property)—the last one stands out as a powerful force when 10 empirical facts are considered together. Therefore, our results stress the importance of future research to understand the underlying reasons for slower knowledge diffusion. To this end, we conclude our study by presenting some brand-new, striking trends on the increased concentration of patents through both their production and purchase by market leaders, as well as on the strategic use of patents, especially since the early 2000s. We also show that a similar trend of concentration has been taking place in the realm of inventors. We hope that these findings ignite a broader conversation in the literature.

The rest of the paper is organized as follows. §2 reviews the literature; it also revisits the empirical trends that the literature has interpreted as the signs of declining business dynamism. §3 introduces the theoretical model and the empirical evidence motivating it, and §4 describes its calibration. §5 and §6 present the experiments that identify and quantify the importance of each margin, using the calibrated model. §7 discusses the welfare implications. §8 investigates the implications of additional channels with regard to observed empirical trends and provides a summary of robustness exercises. §9 presents new empirical facts on the use of intellectual property and the concentration of inventors in mature firms in the US economy, which could shed some light on the reasons knowledge diffusion has slowed over time. §10 concludes.

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