How do demand and costs affect the nature of innovation?

This paper describes how process and product innovations respond to cost and demand changes. In the present model firms simultaneously choose process and product innovations within a model of vertical differentiation and uncovered market. We show that the outcome is unique both in monopoly and in the duopoly. In these outcomes, a demand increase (decrease) enhances (depresses) both process and product innovation, while an increase (decrease) in production costs stimulates (depresses) process innovation but lowers (increases) product one. The insight for these results relies on the scale effect of innovation. Our result can be placed in the ongoing debate on complementarity and substitutability of process and product innovation.