Abstract
We build a model of firm-level innovation, productivity growth and reallocation featuring endogenous entry and exit. A key feature is the selection between high- and low-type firms, which differ in terms of their innovative capacity. We estimate the parameters of the model using detailed US Census micro data on firm-level output, R&D and patenting. The model provides a good fit to the dynamics of firm entry and exit, output and R&D, and its implied elasticities are in the ballpark of a range of micro estimates. We find industrial policy subsidizing either the R&D or the continued operation of incumbents reduces growth and welfare. For example, a subsidy to incumbent R&D equivalent to 5% of GDP reduces welfare by about 1.5% because it deters entry of new high-type firms. On the contrary, substantial improvements (of the order of 5% improvement in welfare) are possible if the continued operation of incumbents is taxed while at the same time R&D by incumbents and new entrants is subsidized. This is because of a strong selection effect: R&D resources (skilled labor) are inefficiently used by low-type incumbent firms. Subsidies to incumbents encourage the survival and expansion of these firms at the expense of potential high-type entrants. We show that optimal policy encourages the exit of low-type firms and supports R&D by high-type incumbents and entry.
Highlights
Industrial policies that subsidize incumbent ...rms, either permanently or when they face distress, are pervasive
Despite the various dimensions of ...rm-level decisions, heterogeneity, and selection e¤ects, which will prove important in our estimation and quantitative exercises, we show that the model is tractable and that much of the equilibrium can be characterized in closed form
We model this in the following tractable manner: each active ...rm receives a positive innovation shock at the rate % per product line, and following this, it adds one of the inactive product lines into its portfolio
Summary
Industrial policies that subsidize (often large) incumbent ...rms, either permanently or when they face distress, are pervasive. The balance of these two forces will determine whether young (and small) ...rms are more innovative and contribute more to growth This feature implies that the key dimension of reallocation in our model is that of skilled labor used for R&D and for ...xed operating costs. They show R&D expenditures by shipments, employment growth and exit rates between small, large, young and old ...rms. The allocation of resources and growth can be signi...cantly improved by exploiting the selection e¤ect, which is only weakly utilized in equilibrium This involves encouraging the reallocation of R&D resources (skilled labor) from low-type incumbents to high-tech incumbents and entrants, and if done e¤ectively, it can increase growth and welfare by a signi...cant amount. The last section concludes, while Appendix A contains some of the proofs omitted from the text, and Appendix B, which is available online, contains additional proofs and results
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