A model of creative destruction with undiversifiable risk and optimising households

Abstract

This paper studies optimal household behaviour in a model of creative destruction. The saving technology is characterised by stochastic returns that follow a Poisson process. It is shown that equilibrium conditions with optimising households differ substantially from equilibrium conditions where investment in R&D is determined by firms. Three out of four market failures disappear and a new market failure resulting from a complementarity in financing R&D is identified. Studying the social optimum shows that it contains as the special case of risk neutrality the social optimum derived in the literature.