Investment and Innovation in Emerging Versus Advanced Market Economies: a Schumpeterian Approach

Abstract

We present empirical evidence that emerging market economies innovate less while they invest more than advanced market economies. We present empirical evidence that innovative activities in both advanced and emerging market economies are most hampered by financial and economic cost factors. To explain the differences in the innovation activity between emerging and advanced market economies, we use two variants of a Schumpeterian model of creative destruction: a variant with complete financial markets and another with incomplete financial markets and uninsurable shocks to the innovation activity and we identify the first with an advanced market economy and the second with an emerging market economy. We characterize the effects of macroeconomic, financial, and industrial factors on the innovation-to-maintenance mix in advanced versus emerging market economies. Economic recessions induce innovation in advanced market economies; however, their effect in emerging markets depends on the underlying parameters of the shock process. In both advanced and emerging market economies, uncertainty induces greater innovation. Borrowing capacity increases innovation in emerging market economies. Industrial competition decreases innovation in emerging market economies, though it is neutral in advanced market economies. In emerging market economies, it is the relative magnitudes of industrial competition and borrowing capacity that matter for innovation. The analysis suggests a different framework for public policy in which industrial competition policy and public financial policy are intertwined.