# **1. Introduction**

Firm exit along with entry are crucial components of the evolution of industries both in developed and in developing countries (Caves, 1998, Tybout, 2000). Models of industry dynamics emphasizing producer heterogeneity and market selection such as Jovanovic (1982) and Ericson and Pakes (1995) suggest that in reasonably efficient markets „superior‟ firms have higher chances to survive and grow. While being innovative is a central characteristic of „superior‟ firms it also is a risky venture due to the uncertainties inherent to both the innovations themselves and their commercialization. The introduction of new products by a firm - an important type of innovation - involves high and often sunk development and production costs that may fail to bring a sufficiently high payoff to recover those costs.<sup>1</sup> Demand for these new products might not pick up or the products could be copied or replaced quickly by other new products developed by competitors. The model proposed by Ericson and Pakes (1995) illustrates the risks associated with innovation. In their model, firms engage in R&D investments which may improve their efficiency, profits, and survival but can also lead to firm exit if the outcome is not successful. Given that failed product launches are frequent, innovators might ultimately face a lower survival probability than other firms.<sup>2</sup> In this paper, we examine the relationship between product innovation and plant survival focusing specifically on the role of different types of risk for that relationship and on potential differences in performance returns for riskier types of innovation. We do so using a rich new dataset on Chilean manufacturing plants and all their products during the period 1996-2003.

Our paper makes several contributions to the empirical literature that studies the relationship between survival and observable producer characteristics, namely innovation-related variables, as a way to test the implications of industry dynamics models.<sup>3</sup> First, our dataset allows constructing objective plant-level time-varying measures of product innovation - categorical and continuous - based on the observation of whether a product is newly manufactured by a plant in any year. This is a clear advantage relative to previous studies that mostly use measures of innovation based on subjective perceptions of managers for a cross-section of firms taken from innovation surveys.<sup>4</sup>

> 1 See OECD-Eurostat (2005) for a discussion of different types of innovation: product innovation, process innovation, managerial innovation, and organizational innovation.

> 2 See Gourville (2006) on the failure of new product introductions. Famous examples of failed product launches include New Coke by Coca Cola and Sony‟s Betamax.

> 3 See Doms et al. (1995), Chen (2002), Disney et al. (2003), and Shiferaw (2009) and Manjon-Antolin and ArauzoCarod (2008) on the determinants of firm survival and Esteve-Pérez et al. (2004), Hall (1987), Cefis and Marsili (2006), and Zhang and Mohnen (2011) on the on the role of innovation for firm survival.

> 4 Mairesse and Mohnen (2010) point to the problems with innovation surveys‟ subjective measures that rely exclusively on firm perceptions of whether they have introduced innovations at the process or product levels. They

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