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Innovation, industry equilibrium, and discount rates

Author

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  • Bustamante, Maria Cecilia
  • Zucchi, Francesca

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. JEL Classification: G31, G12, O31

Suggested Citation

  • Bustamante, Maria Cecilia & Zucchi, Francesca, 2023. "Innovation, industry equilibrium, and discount rates," Working Paper Series 2835, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20232835
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    References listed on IDEAS

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    More about this item

    Keywords

    creative destruction; risk premia; time-varying discount rates; Vertical and horizontal innovation;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • O31 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Innovation and Invention: Processes and Incentives

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