Innovation and the Evolution of Industries: a Tale of Incentives, Knowledge, and Needs.

This chapter is about the co-evolution of technology and markets. Since our goal is to understand the way these forces impact the advancement of industry, these cannot effectively be independently analyzed. Classical economists recognized that the link between technological evolution and market forces is the trigger of industrial revolution, as well as the consequential tumultuous process of economic growth: ‘In turning from the smaller instruments in frequent use to the larger and more important machines, the economy arising from the increase of velocity becomes more striking’ (Babbage, 1832, pp. 4–36). However, Adam Smith noted that the use of ‘more important machines’ is limited by the extent of the market. He described the combined effect of innovation, which creates new markets, and of new markets, which creates incentives for innovation. Karl Marx highlighted the role of machines as the main source of productivity increases as well. Marx also recognized that low wages lead to demand shortages. Despite the awareness of the classical economists, the analysis of the co-evolution of technology and markets as the principal determinants of industrial dynamics is abandoned in traditional neoclassical theory. A certain extension of this approach is found only in the search for incentives responsible for the direction and nature of technological progress.