- 02 May 2013
- Working Paper
Innovation, Reallocation, and Growth
Executive Summary — Industrial policies that subsidize (often large) incumbent firms, either permanently or when they face distress, are pervasive. Despite the ubiquity of such policies, their effects are poorly understood. They may encourage incumbents to undertake greater investments, increase productivity, and protect employment. But they may also reduce economic growth by discouraging innovation by both entrants and incumbents and slowing down reallocation. The reallocation implications of such policies may be particularly important because the existing literature attributes as much 80 percent of productivity growth in the United States to reallocation when less efficient firms exit and more efficient firms enter. In this paper, the authors build a model of firm innovation and growth that enables an examination of the forces jointly driving innovation, productivity growth, and reallocation. This model fits the key moments from microdata reasonably well, and is in line with the range of micro estimates in the literature. Key concepts include:
- This general equilibrium model, incorporating both reallocation and selection effects, highlights the potential pitfalls of industrial policies supporting incumbents, particularly large incumbents.
- Industrial policies (subsidies to incumbent R&D or to their operating costs) reduce growth and welfare, while entry subsidies have a positive but very small effect.
- Optimal policy, which can have substantial innovation and growth gains, simultaneously encourages the exit of under-performing incumbent firms and supports R&D by high-type incumbents and new entrants.
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.