Optimal Diversity in Investments with Recombinant Innovation

Abstract

The notion of dynamic, endogenous diversity and its role in theories of investment and technological innovation is addressed. We develop a formal model of an innovation arising from the combination of two existing modules with the objective to optimize the net benefits of diversity. The model takes into account increasing returns to scale and the effect of different dimensions of diversity on the probability of emergence of a third option. We obtain analytical solutions describing the dynamic behaviour of the values of the options. Next diversity is optimized by trading off the benefits of recombinant innovation and returns to scale. We derive conditions for optimal diversity under different regimes of returns to scale. Threshold values of returns to scale and recombination probability define regions where either specialization or diversity is the best choice. In the time domain, when the investment time horizon is beyond a threshold value, a diversified investment becomes the best choice. This threshold will be larger the higher the returns to scale.