As emphasized by Bresnahan and Trajtenberg (1995), the presence of a general-purpose
technology gives rise to both vertical and horizontal externalities in the innovation process that
can lead not just to underinvestment but also to distortions in the direction of investment,
depending on the degree to which private and social returns diverge across different application
sectors. Most notably, if there are “innovation complementarities” between the general purpose
technology and each of the application sectors, lack of incentives in one sector can create an
indirect externality that results in a system-wide reduction in innovative investment itself. While
the private incentives for innovative investment in each application sector depend on its the
market structure and appropriability conditions, that sector’s innovation enhances innovation in
the GPT itself, which then induces subsequent demand (and further innovation) in other
downstream application sectors.