INNOVATION AND GROWTH WITH FINANCIAL, AND OTHER, FRICTIONS

• Author: Cesaire Meh,Jonathan Chiu,Randall Wright
• Published date: 01 February 2017
• DOI: http://doi.org/10.1111/iere.12210
• Date: 01 February 2017

INTERNATIONAL ECONOMIC REVIEW

Vol. 58, No. 1, February 2017

INNOVATION AND GROWTH WITH FINANCIAL, AND OTHER, FRICTIONS∗

BYJONATHAN CHIU,CESAIRE MEH,AND RANDALL WRIGHT1

Bank of Canada, Canada, and Victoria University of Wellington, New Zealand; Bank of

Canada, Canada; University of Wisconsin–Madison,Federal Reserve Bank of Chicago, Federal

Reserve Bank of Minneapolis,and NBER, U.S.A.

The generation of ideas and their implementation are crucial for economic performance. We study this in a model of

endogenous growth, where productivity increases with innovation and where the exchange of ideas(technology transfer)

allows those with comparative advantage to implement them. Search, bargaining, and commitment frictions impede the

idea market, however, reducing efficiency and growth. We characterize optimal policies involving subsidies to innovative

and entrepreneurial activity, given both knowledge and search externalities. The role of liquidity is discussed. We

show intermediation helps by financing more transactions with fewer assets and, more subtly, by ameliorating holdup

problems. We also discuss some evidence.

1. INTRODUCTION

It is commonly argued that the generation of new ideas and their implementation are major

factors underlying economic performance and growth, and that financial development plays

a role in this process.2This project is our attempt to better understand the issues in a model

where decisions to innovate and implement new ideas are endogenous. Based on the premise

that some people are better at research and others at development, the model incorporates a

market for ideas in order to study technology transfer. This market helps get ideas into the hands

of those better able to implement them, but is hindered by search, bargaining, and commitment

frictions that slow reallocation and hence the advance of knowledge. Realistically, our idea

market is thin, agents are not price takers, and there are fixed costs that are hard to recoup due

to holdup problems. Also, commitment problems impede credit, generating a role for liquidity.

We show how financial intermediaries (e.g., banks) contribute to growth in two ways: They

reallocate liquidity to those that need it most, and, perhaps more surprisingly, they ameliorate

holdup problems.

By way of preview, in our setup, individual producers have access to the frontier technology

Zbut may also come up with ideas for innovation that increase their own productivity to z>Z.

This raises individual profit in the short run, but later knowledge enters the public domain. In

the simplest case, an innovator with an idea tries to develop it on his own and succeeds with

probability σ, indexing the quality of the match between the idea and his expertise. Innovations

∗Manuscript received October 2014; revised October 2015.

1We thank many friends and colleagues for comments on this projects; it has been presented too many times

and we have talked to too many people to try and list them all. Wright acknowledges a research grant from the

NBER’s Innovation Policy working group, as well as support from the Bank of Canada, the NSF, and the Ray Zemon

Chair in Liquid Assets at the Wisconsin School of Business. We also thank Kevin Devereux and Tete Barrigah for

research asistance. The views expressed here do not necessarily reflect the position of the Bank of Canada, the Federal

Reserve Bank of Minneapolis or Chicago, or the Federal Reserve System. Please address correspondence to: Jonathan

Chiu, School of Economics and Finance, Victoria University of Wellington, Rutherford House - 23 Lambton Quay,

Wellington, 6140, New Zealand. Phone: +64 4 463 9728. Fax: +64 4 463 5014. E-mail:jonathan.chiu@vuw.ac.nz.

2An early proponent of the view that financial factors are crucial for growth is Goldsmith (1969), but there is by now

a large literature. See Aghion and Howitt (1997), Levine (2005), and Acemoglu (2009) for comprehensive treatments

and bibliographies. See Greenwood et al. (2010, 2013), Opp (2010), and Cole et al. (2011) for recent papers with more

references.

95

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(2017) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

96 CHIU,MEH,AND WRIGHT

advance individual productivity and collectively determine the evolution of the technology

frontier. The model has a balanced-growth equilibrium, where the growth rate depends on

the number of innovators, their probabilities of success, the distance by which innovations

increase individual productivity, and the way they aggregate to move the frontier. Naturally,

since knowledge is (partially) a public good, equilibrium is inefficient absent intervention, and

we characterize the optimal corrective subsidy. This benchmark model is, however, only a

stepping stone toward studying economies where individuals do not necessarily develop their

own ideas.

As discussed in the literature, the question is this: When people come up with new ideas,

should they try to implement them on their own or trade them to others, say entrepreneurs

who may be better at development, marketing, and related activities? Given heterogeneity in

abilities, it is beneficial if some specialize in research and others in development. As Katz and

Shapiro (1986) say: “Inventor-founded startups are often second-best, as innovators do not

have the entrepreneurial skills to commercialize new ideas or products.” As The Economist

(2005) puts it: “As the patent system has evolved, it . . . leads to a degree of specialization that

makes business more efficient. Patents are transferable assets, and by the early 20th century

they had made it possible to separate the person who makes an invention from the one who

commercializes it. This recognized the fact that someone who is good at coming up with ideas is

not necessarily the best person to bring these ideas to market.” And as Lamoreaux and Sokoloff

(1999) say: “The growth of the U.S. economy over the 19th century was characterized by a sharp

acceleration of the rate of inventive activity and a dramatic rise in the relative importance of

highly specialized inventors as generators of new technological knowledge. Relying on evidence

compiled from patent records, we argue that the evolution of a market for technology played a

central role in these developments” (emphasis added).

Our idea market has a liquidity problem, motivated by limited commitment, which impedes

credit. This is especially important because knowledge is difficult to collateralize—if you sell

someone an idea on credit and they renege, can you repossess the information? Of course, that

depends on intellectual property rights, patent protection, etc. Perhaps less obviously, it also

depends on search frictions that mean entrepreneurs do not know in advance who they will meet

and hence do not know how much liquidity they may need. This leads to a role for intermediation,

which reallocates liquidity and hence redirects resources to more productive users. Here the

resources in question are ideas. In fact, the theory applies to any factor of production, but we

frame the discussion in terms of ideas, consistent with these factors expanding knowledge and

the notion that knowledge is a (partially) nonrival good. Again, equilibrium is inefficient, and

we characterize optimal subsidies to innovative and entrepreneurial activities. These results are

novel, we think, because of the interaction between knowledge and search externalities. We

also show how it is easier to achieve efficiency with than without intermediation.

Although we formally model direct technology transfer, we understand that this is but one

mechanism by which innovators and entrepreneurs interact—for example, they can also enter

into longer-term partnerships, as with venture capital. We are pretty sure that many of the same

insights would emerge in a model with partnerships, but, for several reasons, we concentrate on

situations where innovators want to sell their ideas outright. One very important advantage of

direct transfers is that they avoid strategic problems with joint implementation. Another is that

they allow innovators to go “back to the drawing board” to come up with more new ideas, which

is their forte, instead of getting tied up in development. Moreover, direct technology transfers

have been somewhat neglected in theory, and we think they are worth studying, even if they

are just one of many contributors to economic growth. And we think it is important to model

this market as one with frictions, although, to focus on other issues, this article abstracts from

private information.

The focus instead is on how search, bargaining, and liquidity problems interact with inno-

vation and how this generates a role for financial intermediation that has not been previously

recognized. As usual, one reason to study markets with these frictions is that we can think of

perfect competitive markets as a limiting case. However, people who study this market claim