Abstract

This paper studies the efficiency of process and product innovation in a model that nests many previous theories of knowledge diffusion and selection. It characterizes the equilibrium and optimal allocations, and derives a set of taxes and subsidies that achieve the latter. In the presence of knowledge spillovers, the endogenous exit decision of an incumbent firm generates externalities for other firms. These externalities further lead to a new source of misallocation in investments in process and product innovation across incumbent firms. This is because the return to these investments is heterogeneous and depends on the expected lifetime of before exit. The fact that exit decisions are optimal only from the perspective of the private firm leads to a heterogeneous gap between private and social return to process innovation. A calibration of the model to firm-level data from US manufacturing and retail trade suggests that these misallocations may be quantitatively large and constitute an important consideration for the design of innovation policy.

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