Investment and Innovation In Emerging versus Advanced Economies. A Schumpeterian Equilibrium Approach

Purpose: emerging economies lead advanced economies in world investment but lag advanced economies in innovation. We purpose to understand the paradox.Approach: we set up an equilibrium model of an economy with features that can give rise to generally acceptable characteristics of advanced and emerging economies. We compare the properties of the equilibrium solutions of the model for advanced and emerging economies. We use a Schumpeterian model of endogenous growth with uninsurable idiosyncratic risks to the innovation process and financial constraints. We parameterize the model in correspondence to general characteristics of advanced and emerging economies namely: expected growth in profitability and volatility of profitability in emerging economies versus advanced economies and we compare total investment and the innovation-to-maintenance investment ratio in the two economic environments. We consider the role of size of idiosyncratic risks to the innovation process, firms’ net worth and borrowing constraints and intensity of competition in the market for products.Findings: we find that for small uninsurable risks to the innovation process the model generates the counterfactual predictions of smaller investment and greater innovation in the emerging economy than in the advanced economy. For large uninsurable risks to the innovation process the model generates greater investment and smaller innovation in the emerging economy. Intensity of competition in the product market reduces investment and innovation. We identify the advanced version of the model economy with a model of an economy on the technological efficient frontier and the emerging version with an economy behind the efficient frontier.Originality: we follow the Schumpeterian approach to economic growth and build on seminal work on the relation between creative destruction and the business cycle introducing industrial contest. We are giving the time dimension of the Schumpeterian creative destruction (business cycle) the interpretation of a spatial dimension (geography) and we derive conclusions that increase our understanding of investment and innovation in emerging versus emerging economies.Research implications: we make a number of theoretical predictions about the determinants of investment and innovation that can stimulate further theoretical and empirical research in emerging markets. Further theoretical research include the effects of industrial structure, multinational enterprises and institutional design. Researchers can calibrate the model to the desired empirical data for simulating and predicting the effects of a large range of changes in the economic environment and policy regimes. Policy implications: we point at macroeconomic, financial and institutional factors that advance innovation. We contend that greater firm size and less intense competition in product markets advance innovation in emerging economies whereas the opposite may be true in advanced economies. Implications of particular policy changes can be analyzed on the basis of model simulations to particular economies