Growth and Welfare Implications of Sector-Specific Innovations

I examine the optimal government subsidy of R&D activities when sectors are heterogeneous. To this end, I build an endogenous growth model where R&D drives macroeconomic growth and firm dynamics in two sectors with different characteristics: consumption-goods sector and investment-goods sector. I highlight how various externalities in the innovation process affect the allocation of innovative resources across industries. I calibrate the model to U.S. data and study the quantitative properties of the model. By explicitly examining the transition path after the change in subsidy, I highlight the tradeoff between the consumption level in the short run and the long-run growth. I find that the optimal combination of the subsidy rates as a fraction of firm R&D expenditures is 83 percent in consumption sector and 88 percent in investment sector. By moving from the baseline subsidy rates (10 percent in both sectors), the society can achieve 21 percent welfare gain in consumption equivalent terms. The annual GDP growth rate increases from 1.6 percent to 3.3 percent by this change in subsidy. I also analyze the optimal combination of R&D subsidies when the government budget is limited.