An Explanation of the Inverted-U Relationship between Profitability and Innovation

This book formulates two innovation models that explain the inverted U-shaped relationship between profitability and innovation, and the relationships between profitability and the differences in productivity between individual firms within a given sector, as found by Aghion et al. (2005) and Hashmi (2005). The basic model offers a simple and general explanation for these stylised facts, while the prospect-theory model presents a specific explanation for the stylised facts that incorporates a behavioural theory of managerial decision-making. For certain parameter values, both models generate predictions that correspond to the relationships found by Aghion et al. (2005) and Hashmi (2005). Furthermore, it is shown that both models also produce realistic predictions for a wider range of parameters around these specific values.