Productivity, Demand and Growth
Modern theories of endogenous growth posit a tight link between firm-level productivity, creative destruction (business survival and expansion) and aggregate economic growth. However, recent empirical evidence suggests that firm-level survival and growth are largely demand-driven. We integrate these empirical patterns into a new endogenous growth model in which heterogeneous firms survive and innovate based on not only productivity, but also demand. We show analytically that firm-level demand variation impacts aggregate growth by changing firms’ incentives to innovate. In addition, firms with higher expected demand growth respond more strongly to R&D subsidies. Taking our model to U.S. Census firm data, we estimate that 20% of aggregate growth is demand-driven. Moreover, allowing for demand-driven creative destruction has strong policy implications as it substantially alters the economy’s responses to pro-growth interventions. Finally, we find direct empirical support for our model mechanism in firm-level data.