Growth and the Cycle: Creative Destruction versus Entrenchment

Newly established firms often try to secure their market position by building up a base of loyal customers. While recessions may not destroy technological leadership, they may be harmful for such firm-customer relationships. Without such customer bases, these firms find themselves more vulnerable to attacks by competitors. We formulate this idea within an Aghion-Howitt-type model of creative destruction and discuss its implications for growth. In the context of this model, recessions might be good for growth since they weaken the incumbent firm’s position, and thereby stimulate research by outside firms. The model allows for the extreme case where the leading firm can be so entrenched that growth ceases, unless a recession shakes up its customer base. We find a one-toone relationship between the average growth rate and the cyclical variability, a U-shaped relationship between the average speed of building up good customer relationships and the average growth rate, and a positive relationship between the arrival rate of recessions and average growth. It is finally shown that an appropriate stochastic tax program can implement the social planner’s solution. In some cases, general equilibrium effects may generate interesting results, conflicting with intuition from a partial equilibrium approach: we show that, in some cases, a social planner might want to subsidize research in order to discourage it.