Heterogeneous Innovations, Firm Creation and Destruction, and Asset Prices∗

We study the implications of the creative destruction lifecycle of innovation for asset prices. We develop a general equilibrium model of endogenous firm creation and destruction where “incremental” innovations by incumbents and “radical” innovations by entrants drive the volatility of growth prospects of the economy. Higher entry—bigger threat of displacement of incumbents by entrants—implies higher incumbent betas (cash flow channel) and lower market price of risk (discount rate channel). Furthermore, less market power implies higher incumbent betas and lower market price of risk. Economies with low barriers to entry in innovation and competitive product markets are thus less risky. The effect of competitive forces on incumbents’ cost of capital is ambiguous. Empirical evidence using data on patenting activity in the US supports the model’s predictions. JEL Classification: E22; G12; O30; O41