In the economic literature R&D plays an important role in at least two different ways. First, in the theory of industrial organization and also in the theory of international trade R&D is seen as a strategic variable by which firms conquer, or at the least preserve, market shares, and governments give their domestic firms a competitive edge in international trade, either through cost reductions (in the case of process R&D) or through product differentiation (in the case of product R&D). Second, in growth theory and in the management literature R&D is seen as an investment in knowledge or in absorptive capacity and hence indirectly as a contributor to economic growth. I want to concentrate on the second aspect.
How can R&D contribute to economic growth? Remember Robinson Crusoe. He is stranded on his island and has to find ways to survive. First he uses his own labor to grow fruits and vegetables and to catch fish. Economists would call this the labor input. Then, he figures out that by devoting some of his time to make better fishing rods and agricultural tools he is able to raise his productivity: grow more vegetables and catch more fish with the same amount of effort. The equipment used to produce other commodities is what economists call the capital input. So far Robinson has spent 20% of his time producing capital equipment and 80% of his time fishing and harvesting. Now that he produces enough to survive, he starts spending some time away from production, thinking about producing ever more performing production equipment or new varieties of crop. Robinson Crusoe has discovered the power of research. From now on he spends 20% of his time producing capital equipment, 10% of his time thinking and 70% of his time fishing and harvesting. We could complicate the story but let’s leave it at that and remember from this simple story that production has been obtained by using three inputs: labor, capital and R&D.
R&D plays a central role in the new theory of economic growth, called endogenous growth theory, which is based on the idea that growth does not fall like manna from heaven but can be explained by R&D efforts leading to new products (consumer goods or investment goods) and new knowledge (see the work by Romer (1990), Arrow (1962), Grossman and Helpman (1991), and Aghion and Howitt (1998)). R&D has two properties that set it apart from ordinary investment in machines, namely the fact that the knowledge derived from R&D is non-rival and partly non-excludable, which means that knowledge can be used simultaneously by two different persons without losing any of its content, and that it cannot always be prevented from being used by others. Hence the innovator cannot appropriate all the benefits from his new ideas. Part of it leaks out to others. In practice R&D has two effects. It can lead to new commodities, on which the innovator gains temporary monopoly profits (i.e. profits derived from the fact that he is the own producer, without competitors driving the profit down to zero), and it can lead to new knowledge (in the form of theorems, algorithms, models), which can facilitate subsequent innovations. Because of the impossibility of perfect price discrimination, a part of the monopoly rents get transferred to other producers or the consumers. For instance, we all seem to derive a benefit from using computers which is greater than the price that we paid for acquiring them. Zvi Griliches (1979) called this first R&D spillover “rent spillover” to distinguish it from the second one, which has to do with the free transmission of knowledge and which he called “knowledge spillover”. The non-appropriability of the entire benefits from R&D and the intertemporal externalities of R&D keep the benefits of R&D from dropping below the discount rate and hence maintain the incentives to invest in R&D, and therefore assure sustained growth.
