Innovation, Industry Equilibrium, and Discount Rates

Abstract

We develop a model to examine how aggregate discount rates affect the nature and composition of innovation within an industry. Challenging conventional wisdom, higher discount rates do not discourage innovation when accounting for the industry equilibrium. Higher discount rates deter entry—effectively acting as entry barriers—but encourage innovation through the intensive margin, which can lead to a higher industry innovation on net. Simultaneously, high discount rates foster explorative over exploitative innovation. Our predictions strengthen in industries with higher exposure to aggregate risk, for which the negative impact of discount rates on entry is stronger.

Keywords: Vertical and horizontal innovation, creative destruction, discount rates, risk premia

JEL Classification: G31, G12, O31