Innovation, Industry Equilibrium, and Discount Rates

60 Pages Posted: 22 Jul 2021

See all articles by Maria Cecilia Bustamante

Maria Cecilia Bustamante

University of Maryland - Department of Finance

Francesca Zucchi

Federal Reserve Board

Date Written: July 19, 2021

Abstract

We develop a model to examine how discount rates affect the nature and composition of innovation within an industry. Challenging conventional wisdom, we show that higher discount rates do not discourage firm innovation when accounting for the industry equilibrium. Higher discount rates deter fresh entry---effectively acting as entry barriers---but encourage innovation through the intensive margin, which can lead to a higher industry innovation rate on net. Simultaneously, high discount rates foster explorative over exploitative innovation. Considering fluctuations in discount rates, the model further rationalizes observed patterns in innovation cyclicality, and shows that innovation by rivals inflates incumbents' risk premia.

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

JEL Classification: G31, G12, O31

Suggested Citation

Bustamante, Maria Cecilia and Zucchi, Francesca, Innovation, Industry Equilibrium, and Discount Rates (July 19, 2021). Available at SSRN: https://ssrn.com/abstract=3889442 or http://dx.doi.org/10.2139/ssrn.3889442

Maria Cecilia Bustamante (Contact Author)

University of Maryland - Department of Finance ( email )

Robert H. Smith School of Business
Van Munching Hall
College Park, MD 20742
United States

HOME PAGE: http://https://sites.google.com/a/rhsmith.umd.edu/mcbustam/?pli=1

Francesca Zucchi

Federal Reserve Board ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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