Out-of-equilibrium profit and innovation

Abstract

Innovation is the result of intentional decision-making that takes place in out-of-equilibrium conditions. Profitability is a reliable indicator of equilibrium conditions, far better than competition, as it integrates the effects of out-of-equilibrium conditions in both product and factor markets. The farther the profitability from the average, the deeper the out-of-equilibrium conditions. The farther away the firm from equilibrium, the stronger the likelihood for innovation to take place. The hypothesis of a U-shaped relationship between levels of profitability and innovative activity, as measured by the rates of increase in total factor productivity (TFP), is articulated and tested. The evidence from a large sample of 7000 Italian manufacturing firms in the years 1996–2005 confirms the presence of a quadratic, convex relationship between profitability and the growth rates of TFP.

Keywords:

• endogenous technological change
• out-of-equilibrium
• profitability
• innovation
• total factor productivity

JEL Classification :

• O33

Acknowledgements

The authors acknowledge the financial support of the European Union D.G. Research with the Grant number 266959 to the research project ‘Policy Incentives for the Creation of Knowledge: Methods and Evidence’ (PICK-ME), within the context Cooperation Program/Theme 8/Socio-economic Sciences and Humanities (SSH) in progress at the Collegio Carlo Alberto, and of the University of Torino and the Politecnico of Torino.

Notes

The sample has not been built using stratification techniques that would make it a representative sample of the Italian population of firms. However, the magnitude of the sample is considerable to draw robust results. We do not consider market exit/entry.

The choice of the depreciation parameter in the perpetual inventory method follows the approach by previous studies on productivity. Results are not affected by slight changes of the parameter.

For a discussion of the properties of different estimation approaches, see Blundell and Bond (2000) and Olley and Pakes (1996).

Industries have been selected on the basis of availability of sufficient observations and representativeness of sectors with different structural characteristics.