Innovation and Strategic Network Formation

We study a model of innovation with a large number of firms that create new technologies by combining several discrete ideas. These ideas are created via private investment and spread between firms. Firms face a choice between secrecy, which protects existing intellectual property, and openness, which facilitates learning from others. Their decisions determine interaction rates between firms, and these interaction rates enter our model as link probabilities in a learning network. Higher interaction rates impose both positive and negative externalities, as there is more learning but also more competition. We show that the equilibrium learning network is at a critical threshold between sparse and dense networks. At equilibrium, the positive externality from interaction dominates: the innovation rate and welfare would be dramatically higher if the network were denser. So there are large returns to increasing interaction rates above the critical threshold. Nevertheless, several natural types of interventions fail to move the equilibrium away from criticality. One effective policy solution is to introduce informational intermediaries, such as public innovators who do not have incentives to be secretive. These intermediaries can facilitate a high-innovation equilibrium by transmitting ideas from one private firm to another.