Max number of products per innovation n Turnover rate Endogenous f Exogenous f Fixed coupon Figure 9: The effects of the endogenous rate of creative destruction. The figure shows the effects of changing the cost of innovation and the quality of investment oppor- tunities on outcome variables in the single-firm model and in industry equilibrium. The comparative statics for leverage are smoothed using a third-order polynomial 32 Electronic copy available at:
By contrast, when f is exogenous, increasing n decreases the turnover rate. Again this is due to the fact that in the latter case, an increase in n only leads to a decrease in leverage. Another result illustrated by the top right figure of Panel B is that an increase in n leads to a decrease in leverage when financing decisions are endogenous. By contrast, with a fixed coupon, leverage increases with n because the higher rate of creative destruction impairs firm value. III General Equilibrium This section closes the model in general equilibrium to endogenize the growth rate, labor demand, and the interest rate in the economy. The general equilibrium setup builds on Klette and Kortum ( 2004 ). We study a stationary equilibrium with a balanced growth path. This subsection describes the key features of the general equilibrium framework. Appendix D provides a detailed and formal description. There is a representative household with logarithmic preferences who perfectly elastically supplies labor at a fixed wage. Entrants and incumbents use labor to perform R&D and produce goods. All costs in the model come in the form of labor costs, and therefore aggregate production equals aggregate consumption. An innovation improves a product’s production technology and therefore increase ag- gregate production and consumption. Each firm uses one unit of labor for each product line. Given the representative agent’s preferences, this setup implies that a firm’s profits per product line only depend on the wage rate, which allow us to use the industry equilib- rium framework we developed before. As a consequence, all the results derived in industry equilibrium still hold in general equilibrium. This also implies that Proposition 3 , which shows that creative destruction is higher in an industry equilibrium with debt, still holds true in general equilibrium. As we show in Appendix D , this higher rate of creative destruction implies that the growth rate is also 33 Electronic copy available at:
higher in the presence of debt. The following proposition formalizes this result. Proposition 4 (Debt Financing and Growth) . Let g * No Debt be the equilibrium growth rate in case firms are restricted to have no debt. There exists an equilibrium with growth rate g * ≥ g * No Debt .