Endogenous Entry and Optimizing Creative Destruction

Existing studies on Schumpeterian growth theory unanimously specify new entrants’ creative destruction behavior in an ad hoc manner. However, this specification fails to reflect the fact that the replacement of incumbents by new entrants is essentially an optimal decision-making process. To overcome this deficiency, this paper develops a Schumpeterian growth model in which creative destruction arises endogenously from the optimal decision-making of entrant R&D firms, rather than being imposed in an ad hoc manner. The model is then used to examine how R&D-related policies—including patent protection and corporate profit taxation—as well as entry sunk costs affect entrants’ creative-destruction behavior, economic growth, and social welfare. Our theoretical analysis shows that a higher corporate profit tax rate or a higher marginal entry cost reduces the mass of potential new entrants, the optimal probability of creative destruction, and the balanced growth rate, whereas stronger patent protection raises these macroeconomic variables. In addition, our numerical welfare analysis finds that the magnitude of the marginal market entry cost plays a crucial role in determining the optimal levels of patent protection and corporate profit taxation.