Innovation, Knowledge Diffusion, and Selection

This paper constructs a theory of industry growth through innovation and selection- driven creative destruction. Firms' ideas determine their productivity and stochasti- cally evolve over time. Firms innovate to improve their ideas and endogenously exit if unsuccessful. Entrants adopt the ideas of incumbents. In this model, when bet- ter ideas are innovated or adopted, they selectively replace worse ideas. Innovation externalities vary based on firm productivity: ideas generated by more productive firms create 1) longer-lasting positive externalities due to knowledge diffusion and 2) stronger negative externalities due to the displacement of other firms. Therefore, the net externalities of innovation are heterogeneous, and market equilibrium mis- allocates innovation across firms. Solving for the optimal allocation shows that the instruments of innovation policy should depend on firm productivity. A calibration of the model to firm-level data from US manufacturing and retail trade suggests quantitatively large misallocations that create first-order considerations for policy design