Innovation, Industry Equilibrium, and Discount Rates
60 Pages Posted: 22 Jul 2021
Date Written: July 19, 2021
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
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