It's actually pretty much the main problem with capitalism. Innovation often drives prices down, and prices going down means less profit, so at a point, there is an absolute disincentive to innovate. Obviously in theory people would leave the inferior product, but that is clearly not the case in situations like this.
Actually, the more free a market is the less of a problem this becomes. For every Blockbuster Inc. out there perfectly happy with the way things are now, the free market tends to produce three or four Nexflixes who are more than happy to cut margins, innovate and broaden the market.
Of course, with monopolies you get the kind of perverse incentives you're describing. Phone technology and prices stagnated for a decade or two when Bell had a de facto monopoly. I would still argue that a free market tends to produce fewer monopolies than any other practical regulatory scheme, but that's a topic for another post.
It happens in any type of economic system, except in capitalism, it happens much slower. I'd prefer eventual stagnation with the possibility of reviving innovation to a forced stagnation by a particular economic system.
I wouldn't consider capitalism an economic system. It is more of a description of the behavior of organisms. Free markets naturally produce monopolies just like humans have monopolized Earth. Once the monopoly is achieved, the motivation to innovate diminishes along with the entity's competitiveness. Eventually, someone will challenge the monopoly-holding alpha entity and the cycle continues. It happens in economies, societies, ecosystems, and any domain where evolution takes place.
This doesn't make sense. Innovation CAN drive prices down lowering costs. Lower prices lead to increased sales and market share. When prices reach near zero there is certainly a disincentive to innovate, and that is not a "problem". The fact that some consumers don't take advantage if innovation - broadband Internet for the same price as their old dial up - is the problem here. This has nothing to do with any fundamental flaw in capitalism.
