Finance and Schumpterian Rents: On the Timing of Innovation

Abstract

I model an innovation game in which firms can choose to be leaders or followers. Internal finance leads to a stalemate in which each firm wants to free-ride on the others' experimentation costs. Therefore, no innovation occurs. When instead firms compete in the capital markets to finance innovation (e.g., in the case of venture capital) there is an endogenous cost to delay. Waiting to make risky irreversible investment conveys pessimist information. I characterize the relative sizes of waves of leaders and followers in innovation cycles - and the endogenous, intertemporal distribution of quality as each wave builds and crashes - as a function of the risk of the innovation and the amount of external finance required.