Competition Innovation and Growth with Limited Commitment Discussion

Outline Innovative model of growth through creative destruction – conflict of interests Incomplete enforcement and holdup Very important problem Interaction between enforcement problems and competition Surprising results Connection to the data

Surprising results 1.Lack of commitment of investors (holdup) can result in higher growth 2.Lack of commitment of entrepreneur can also result in higher growth 3.Lack of outside opportunities (competition) lowers growth –In case (1) aggravating holdup –In case (2) alleviating lack of commitment

Outside opportunities/no commitment of E Lack of outside opportunities/ commitment of E Investor commits g cn >g * g*g* Investor does not commit (holdup) g nn >g * 0

Surprising results How robust? What features in the model explain this? Key ingredient: activities/investments used as a response to incompleteness: –In model, it is increased HK accumulation –Could be different

1. Holdup problem h1h1 h max S(k,h) S(0,h) Ex-ante value for E Ex-post value for E Ex-post renegotiate down to this lower value But then entrepreneur could do better taking outside option To eliminate this problem, choose instead h max Incidentally, this would also be the choice if the E controls the h decision.

Holdup problem: remedies To get around holdup must do something that increases outside value of E This something could be complement to h investment or substitute. In this model, it is complement: just invest more (enhances investment) Other alternatives possible: spend more time increasing marketability: –go to association conferences in Las Vegas –Invest in some other type of HK If these activities are substitutes (compete with) investment in h, they can reduce investment and growth.

h1h1 h max Ex-ante value for E Ex-post value for E h’h’

2. Outside opportunities and limited commitment for entrepreneur Problem: how does investor manage to break-even. Limited commitment  ex-post renegotiation by entrepreneur. Conflict between efficiency and distribution of surplus. Remedy: Deviate from efficient solution to increase surplus of investor

Lack of E’s commitment: remedies Need to do “something” that increases surplus for investor. Best would be upfront payment Impossible by limited liability Pay with “work” –If this “work” is complement/enhances h then get higher h and higher growth –If this “work” is substitute/competes with h then get lower h and lower growth

Limited commitment in Ak models Results from previous models suggest opposite result Previous models of limited commitment result in borrowing constraints. These borrowing constraints can lower TFP (with fixed costs) In linear growth model, this implies lower growth Remedies  loss of efficiency  lower productivity  lower return to investment and lower growth

The evidence and interpretation Partial correlations between growth and costs of setting up firms only suggestive. Link to model: claim is higher costs imply higher barriers to enter  less competition  lower growth. Effect ambiguous: lack of competition without holdup  commitment on both sides  efficient arrangement  higher productivity There seem to exist more direct channels to explain the evidence: higher cost of setting up firms  decrease returns to investment  decrease

Policy implications Are good institutions bad? –Contracts that limit options for E can be good (prevents E holding up I) if I can commit –But in this model results in lower growth! – Efficiency? Second best world. Optimal policy: –good enforcement –Subsidize h if externalities are important