Dynamics of innovation and risk

Abstract

We study the dynamics of an innovative industry in which agents learn about the likelihood of negative shocks. Managers can exert risk prevention effort to mitigate the consequences of shocks. If no shock occurs, confidence improves, attracting managers to the innovative sector. But, when confidence becomes high, inefficient managers exerting low riskprevention effort also enter. This stimulates growth, while reducing risk prevention. The longer the boom, the larger the losses if a shock occurs. Although these dynamics arise in the first-best, asymmetric information generates excessive entry of inefficient managers, earning informational rents, inflating the innovative sector, and increasing its vulnerability.