Working Paper Series Winners and Losers : Creative Destruction and the Stock Market

We develop a general equilibrium model of asset prices in which the benefits of technological innovation are distributed asymmetrically. Financial market participants do not capture all the economic rents resulting from innovative activity, even when they own shares in innovating firms. Economic gains from innovation accrue partly to the innovators, who cannot sell claims on the rents that their future ideas will generate. We show how the unequal distribution of gains from innovation can give rise to a high risk premium on the aggregate stock market, return comovement and average return differences among firms, and the failure of traditional representative-agent asset pricing models to account for cross-sectional differences in risk premia. Leonid Kogan MIT Sloan School of Management 100 Main Street, E62-636 Cambridge, MA 02142 and NBER lkogan@mit.edu Dimitris Papanikolaou Kellogg School of Management Northwestern University 2001 Sheridan Road Evanston, IL 60208 and NBER d-papanikolaou@kellogg.northwestern.edu Noah Stoffman Kelley School of Business, Indiana University 1309 E 10th Street Bloomington, IN 47405 nstoffma@indiana.edu Technological innovation is arguably the main driver of economic growth in the long run. However, the economic value generated by new ideas is usually not shared equally. The popular press is rife with rags-to-riches stories of new entrepreneurs, whose net worth rose substantially as a result of their innovative ideas during technological booms such as those experienced in the 1990s and the 2000s. In addition to the large wealth gains for successful innovators, technological progress can also create losses through creative destruction, as new technologies render old capital and processes obsolete. We show that the asymmetric sharing of gains and losses from technological innovation can give rise to well-known, prominent empirical patterns in asset price behavior, including a high risk premium on the aggregate stock market, return comovement and average return differences among growth and value firms. We build a tractable general equilibrium model in which the benefits of technological progress are distributed unevenly across investors and firms. Our model allows for two forms of technological progress. Some advances take the form of improvements in labor productivity, and are complementary to existing investments, while others are embodied in new vintages of capital. Throughout the paper we refer to the first type of technological progress as disembodied, and the second type as embodied.1 The latter type of technological progress leads to more creative destruction, since old and new capital vintages are substitutes. A prominent feature of our model is that the market for new ideas is incomplete. Specifically, shareholders cannot appropriate all the economic rents generated by new technologies, even when they own equity in the firms that develop those technologies. Our motivation for this market incompleteness is that ideas are a scarce resource, and the generation of ideas relies heavily on human capital. As a result, innovators are able to capture a fraction of the economic rents that their ideas generate. The key friction is that potential innovators cannot sell claims to these future rents. This market incompleteness implies that technological progress has an asymmetric impact on household wealth. Most of the financial benefits from innovation accrue to a small fraction of the population, while the rest bear the cost of creative destruction. This reallocative effect of technological progress is particularly strong when innovations are embodied in new capital goods. By exposing households to idiosyncratic randomness in innovation outcomes, improvements in technology can thus reduce households’ indirect utility. This displacive effect on indirect utility is amplified when households also care about their consumption relative to the economy-wide average, since households dislike being ‘left behind’. Displacement risk contributes to the equity risk premium and also leads to cross-sectional differences in asset returns. Owning shares in growth firms helps offset potential utility losses Berndt (1990) gives the following definitions for these two types of technology shocks: “Embodied technical progress refers to engineering design and performance advances that can only be embodied in new plant or equipment; older equipment cannot be made to function as economically as the new, unless a costly remodelling or retrofitting of equipment occurs,” and “by contrast, disembodied technical progress refers to advances in knowledge that make more effective use of all inputs, including capital of each surviving vintage (not just the most recent vintage). In its pure form, disembodied technical progress proceeds independently of the vintage structure of the capital stock. The most common example of disembodied technical progress is perhaps the notion of learning curves, in which it has been found that for a wide variety of production processes and products, as cumulative experience and production increase, learning occurs which results in ever decreasing unit costs.”