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The importance of innovative activity by firms for securing economic growth and welfare is by now well recognized and has been widely documented in the scientific literature. Important as it might be, the authors also know that market failure for R&D investment can be quite severe. Firms lacking internal means of finance seek out external sources to finance their innovative activity. However, capital market frictions generated by information asymmetry often lead to a large gap between the cost of external financing and internal financing. This notion of costly external financing stands in contrast to the more complete-markets approach underlying conventional models of investment emphasizing expected future profitability and the user cost of capital as key determinants of investment.
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