Incentive and uncertainty: the simultaneous effects of demand on innovation

This paper develops a macro examination framework for simultaneously testing the incentive effect and uncertainty effect under R&D-based growth theory. A stochastic frontier innovation model with heterogeneity has been established and estimated, in which the exogenous cites’ demand changes measured by market potential increases induced by China’s high-speed rails are introduced into both inefficiency mean equation and inefficiency variance equation. The empirical results show that market potential has significantly negative correlation with inefficiency mean and inefficiency variance, which are robust to various market potential measurement, as well as robust to DID setting and IV regressions. The study provides the first macro evidence for supporting both Schmookler hypothesis and Myers-Marquis hypothesis, and the examination framework has obvious advantages over the previous FG framework.