Financially Constrained Innovation , Patent Protection , and Industry Dynamics ∗

This paper assesses the importance of intellectual property (IP) protection for innovation in the context of a model of the industry dynamics in which business niches can be monopolized by the holders of valuable IP. Successfully developed innovations add to the stock of valuable IP but also detract from it by turning some older IP invaluable. IP may also turn invaluable as a result of imitation. We consider the case in which innovations are generated by financially constrained entrepreneurs who are partly motivated by the search for independent business success. We find that the protection against subsequent innovators is counterproductive for innovation and welfare, while some (generally not full) protection against imitation is good in both dimensions. We also find that the net welfare gains (losses) from increasing IP protection are increasing (decreasing) with the tightness of financial constraints.