A Structural Empirical Model of R & D , Firm Heterogeneity , and Industry Evolution ∗

This paper develops and estimates a dynamic industry equilibrium model of R&D, R&D spill-overs, and productivity evolution of manufacturing plants in the Korean electric motor industry from 1991 to 1996. Plant-level decisions for R&D, physical capital investment, entry, and exit are integrated in an equilibrium model with imperfectly competitive product market. Estimates of the structural parameters explains observed heterogeneity in plant R&D choice, size, and turnover, and quantifies how R&D and R&D spill-overs drive the change of plant productivity and industry structure. Given the structural estimates, I study an important policy question: how does product market competition affect individual firm innovation and aggregate industry productivity? The empirical model is estimated in two steps. In the first step, a model of static market competition is used to estimate the demand elasticity, returns to scale in production, and the process of plant level productivity. The initial productivity distribution for new entrants is also recovered. In the second step, I use a Simulated Method of Moments estimator to estimate the cost of R&D, the magnitude of the R&D spill-over, adjustment costs of physical investment, and the distribution of plant scrap values. To circumvent the computational burden of solving the industry equilibrium with a large number of plants in the second stage estimation, I apply the recent approximation method of Weintraub, Benkard and Van Roy (2005). The industry equilibrium model provides a natural link from individual firm’s R&D decisions to aggregate industry productivity. Counterfactual experiments of two policies are implemented. Increasing the elasticity of substitution between products increases plant innovation incentives but slows the plant turnover. In the long run, a 5% drop in pricecost margin improves industry productivity by 1.9%. In contrast, a lower entry cost, which increases total entry by 50%, does not change industry productivity. Although the market selection effect is strengthened by higher firm turnover, the plant’s incentives to invest in R&D are reduced. ∗I would like to thank my thesis committee Nezih Guner, Mark Roberts, James Tybout, and Gustavo Ventura for their guidance and support. I am also grateful to Boyan Jovanovic, Kala Krishna, Isabelle Perrigne, Bee-Yan Roberts, Andres Rodriguez-Clare, Quang Vuong, Neil Wallace, and especially Gabriel Weintraub for helpful discussions and comments. All remaining errors are mine. †Contact: Department of Economics, Penn State University. Email: yux100@psu.edu.