The purpose of this paper is to provide economic modeling and its implications to government policy in promoting and financing innovation in the creative industries. First, we develop a rational expectation model with emphasis on network externalities (NE) within the creative industries, and on the moral hazard problem due to the presence of asymmetric information in a loan market for innovation. Interactions between firms' and banks' expectations play an important role in determining which of the two equilibria occurs: one with low NE and the other with high NE. Then, we show the effectiveness of policies that critically depend on the current equilibrium and how discrepancies between the expectations converge to a new equilibrium. This paper develops a theoretical model and also empirically tests some implications of the model using OECD country level data (2000–2013). The theoretical results show that policies aiming at promoting innovation in the creative industries actually decrease the equilibrium level of innovation as well as banks' confidence and network externalities in low NE equilibrium even with the presence of the positive effect of lowering the critical mass; the opposite outcomes are observed in high NE equilibrium. Other implications of government policies are also discussed.
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