The direction of innovation

How do innovation policies affect the direction of research? Is market-based innovation too radical or too incremental? We construct a novel and tractable model of the direction of innovation. Firms pursue inefficient research directions because they race to discover easy yet less valuable projects and because they work on difficult inventions where they can appropriate a larger portion of the social value. Fixing these inefficiencies requires policy to condition on properties of inventions that could have been discovered but were not. Policies which do not do so, like patents and prizes, may fail to encourage firms to research in the efficient direction, even if they obtain the optimal quantity of R&D.