Bubbles and the Value of Innovation

Abstract

Episodes of booming innovation coincide with intense speculation in financial markets. What can asset prices teach us about innovations during bubbles? In our theory, investor speculation about which firms will succeed creates a bubble. An innovation raises the stock price of its creator more than justified by future outcomes. However, prices of competing firms do not get penalized even though their profits suffer. These predictions do not arise in alternative theories of bubbles; we confirm them and other aspects of our model using over a million patents. Efficient innovation policy uses information from prices and real outcomes despite their disconnect.