The Aggregate Implications of Innovative Investment in the Garcia-Macia, Hsieh, and Klenow Model

In this paper, we extend the model of firm dynamics of Garcia-Macia, Klenow, and Hsieh (2016) (GHK) to include a description of the costs of innovative investments as in the models of Klette and Kortum (2004), Luttmer (2007, 2011), and Atkeson and Burstein (2010). In this model, aggregate productivity (TFP) grows as a result of innovative investment by incumbent and entering firms in improving continuing products and acquiring new products to the firm. This model serves as a useful benchmark because it nests both Quality-Ladders based Neo-Schumpeterian models and Expanding Varieties models commonly used in the literature and, at the same time, it provides a rich model of firm dynamics as described in GHK. We show how data on firm dynamics and firm value can be used to infer the elasticities of aggregate productivity growth with respect to changes in incumbent firms’ investments in improving their incumbent products, incumbent firms’ investments in acquiring products new to the firm, and entering firms’ investments in acquiring new products. As discussed in Atkeson and Burstein (2015), these elasticities are a crucial input in evaluating the extent to which it is possible to alter the medium term growth path of the macroeconomy through policies aimed at stimulating innovative investments by firms. Using these methods, we find elasticities that are moderately larger than those possible in Neo-Schumpeterian models, corresponding to modest rates of social depreciation of innovation expenditures. Our estimates are sensitive to the extent of business stealing, which is not well identified in our data. ∗Department of Economics, University of California Los Angeles, NBER, and Federal Reserve Bank of Minneapolis. †Department of Economics, University of California Los Angeles, NBER.