Innovation, Industry Equilibrium, and Discount Rates

63 Pages Posted: 22 Jul 2021 Last revised: 7 Nov 2023

See all articles by Maria Cecilia Bustamante

Maria Cecilia Bustamante

University of Maryland - Department of Finance

Francesca Zucchi

European Central Bank

Date Written: July 1, 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. The model rationalizes observed patterns of innovation cyclicality, and predicts that lower entry in downturns hedges innovating incumbents against higher discount rates.

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 1, 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

European Central Bank ( email )

Sonnemannstrasse 20
Frankfurt am Main, 60314
Germany

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