JEL classification: D50; L10; O30

This paper investigates the research and development activity of heterogeneous and rationally bounded firms. The latter whilst nested in a cognitive neighbourhood gather information through interaction with neighbouring firms which produce knowledge spillovers but at the same time are apt to independently discover new innovative ideas through autonomous searching and problem solving. The economy we wish to discuss is portrayed as a simple system of J industries, with J very large. Each industry is made up by two distinct sectors: the first being populated by many firms perfectly competing with each other in producing a final good while the second realizes an innovation which is then embodied in a vital intermediate input to be supplied to the first. Although each such sector may in principle accommodate several firms, we assume that the latter features just two. One is an undisputed technological leader that owns the frontier technology, enjoys the returns of a successful but past innovation and therefore has a monopolistic position supplying final producers whilst the other is a follower that carries out a significant technological searching activity, collects information through costly observation and stands a positive probability of becoming the next successful innovator, thus of driving out the present day incumbent. This process finally leads to an applicable innovation only when the entire information gathering is complete. As long as information remains incomplete no innovation can take place and thus no spillover can be generated. In house activity complements and strengthens this process. We stress the fact that firms by possessing bounded rationality can only observe other firms that are cognitively near and thus located in a reachable neighbourhood. The combination of independent research and local interaction may lead to waves of innovations that under appropriate conditions may embrace the whole system. This event in which innovative activity, at the aggregate level, is highly correlated and in which large fluctuations endogenously emerge, leads to non-negligible global effects.

Innovations raise productivity in successful sectors and by so doing increase aggregate income and thus aggregate demand. This global effect feeds back upon the incentive to innovate and therefore of the strength of local interaction as well as on autonomous research efforts. It is these two dynamic forces that we model. The comparison between cases in which waves do emerge with cases in which they do not, leads to the conclusion that fluctuations at the aggregate level produce an increase in expected firm-level profits and thus enhance growth. The result we obtain is that a higher average innovation avalanche size is associated with  larger fluctuations and a higher long run growth rate.

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