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With few exceptions, induced innovation theories give little consideration either to the role of distortions as determinants of the factor biases of innovations, or to the influence of technical progress – with or without distortions – on the sectoral structure of production. This analysis identifies demand for innovations as a function of a specific policy setting which both conditions and is conditioned by the structure of production. In this context, when some sectors contribute more than others to environmental externalities, private and social optima in the allocation of research resources may diverge. In some circumstances it may be optimal to use research budget allocations as second‐best substitutes for Pigouvian taxes.


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