Acemoglu and colleagues (2013) examine the impact of enterprise reallocation and innovation decisions on aggregate consumption through a complementary general equilibrium model that allows enterprises to differ in their degree of innovativeness and allows exit to be driven by creative destruction (innovation by other firms replaces the leading-edge status of a firm in a particular product line), an exogenous disaster shock, and obsolescence (firms with sufficiently low productivity endogenously exit from product lines). Their model highlights that the decentralized allocation calibrated to US enterprise-level data does not maximize growth or aggregate welfare in consumption equivalents. Indeed, their striking finding is that the allocation that a welfare-maximizing social planner would choose results in a 70% increase in the growth rate (growth increases from roughly 2.2 to 3.8%) with welfare in consumption equivalents increasing by 6.5% relative to the market-based decentralized outcome. A first reason for the divergence between decentralized and efficient equilibria is the traditional knowledge externality and underinvestment in R&D (and some other types of KBC) associated with enterprises not being able to appropriate the full value of new innovations, including the productivity increases to other firms from the increased stock of knowledge. But a more important second reason is a substantial inefficiency in the decentralized equilibrium arising from selection effects: low productivity, low innovation-capacity firms remain active too long because they do not take into account that by freeing resources from the fixed cost of operations for these firms, skilled labor can be reallocated and combined with R&D (and other KBCrelated) inputs – which is not fully internalized by the market because the skilled wage is depressed relative to its social value. So even when their model is calibrated to a relatively well-functioning economy like the US, there are substantial growth and consumption gains from even faster exit of lowinnovation capacity firms and faster entry of high-innovation capacity firms than in a market-based outcome. This suggests significant untapped benefits for consumers from business environments that facilitate more enterprise innovation-related risk-taking, experimentation and learning.

Absent appropriate policies, market incentives for reallocation and innovation can also result in the product and quality mix remaining tilted toward higher-income consumers with the ability to pay, with innovative products that enable improved risk management by the poorest people not being developed or marketed.<sup>34</sup> Illustrative examples of inclusive innovation that enable improved risk management by poor people and may not take place absent some appropriate policy intervention include:

- the novel use of rice husks in India for rural electrification or solar lighting – reducing the fire hazard and health risks from the fine particles in the fumes associated with kerosene-fuelled lanterns, and broadening the risk-absorption capabilities of household members by facilitating home study and other productive activities at night)<sup>35</sup>

- the use of solar panels to power an electrochemical toilet that turns human sanitation waste into useful things such as chlorine (a disinfecting solution used to flush the toilet), hydrogen (suitable for cooking or powering a fuel cell to produce electricity) and residue (used as fertilizer) – this toilet, winner of the Gates Foundation “Reinventing the Toilet” $100,000 first prize, will if widely

> 34 See Dahlman and Kuznetsov (2013) for a categorization of different types of base-of-the-pyramid (BOP) innovation and relevant policy issues. Their working definition of BOP innovation is any organizational and or technical novelty that is likely to be broadly diffused and have an impact on the welfare and living standards of lowincome households through the consumption channel. They do not discuss how innovation helps the BOP population through its impact on income earners through jobs and increasing earnings, or as owners of even small amounts of capital.

> 35 See “Energy technology: Cheaper and better solar-powered electric lights promise to do away with kerosenefuelled lanterns”, _The Economist_ , September 1, 2012.

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