1998-16

May 15, 1998

Reasons for Public Support of Research and Development

Joe Mattey

Federal funding for research and development has ebbed and flowed since the end of World War II (Figure 1). During the 1950s it generally averaged less than ½% of U.S. GDP; in the early 1960s–during the “space race” with the Soviets–it picked up sharply to more than 2% of GDP; and since the mid-1960s, it generally has grown less quickly than the overall economy, drifting back down to less than 1% of GDP currently.

With policymakers focused on keeping the federal budget out of deficit and achieving higher rates of overall economic growth, the extent of public support of research is up for debate: some entertain the possibility of cutting back further on federal research support, and others view increased federal support of research as an efficient means of promoting overall economic growth. Political agendas aside, the economics literature has developed a number of basic reasons for public support of research that help enlighten the debate. This Economic Letter reviews those reasons to explain why private market incentives for research are incapable of guiding the private sector to serve the public interest fully.

Basic knowledge is a public good

The result of research is knowledge, and when viewed as the outcome of an economic process, knowledge has two very special characteristics. First, unlike most other commodities, knowledge is not diminished by using it; in the jargon of economists, one would say that knowledge is “non-rivalrous in consumption.” This makes it more appropriate, from a social point of view, to foster sharing the results of the productive research activity.

Second, it is more difficult to control the use of knowledge than to control the consumption of other types of commodities. That is, establishing enforceable property rights for knowledge can be difficult. Knowledge often is not appropriable for exclusive use; owners often have difficulty doling out the rights to usage to particular individuals. Furthermore, patents generally offer only weak protection for intellectual property rights. Thus, if the production of knowledge were left completely to private markets’ encumbered methods of financing the research, free-riders could benefit from advances in knowledge without paying the costs of developing them.

These two characteristics–non-rivalrousness and the lack of appropriability–make the most basic forms of knowledge public goods. It is difficult for the private sector, driven by its responsibilities to stockholders and to maintaining corporate profitability, to engage in the level of research which is most beneficial to society. Public efforts to support research strive to make up for the shortfall.

The costs of knowledge: big science/big risks

The costs associated with producing and distributing knowledge also are somewhat special in form. Relative to the costs of distributing research results–which are small and now declining rapidly with advances in information and communications technology–there are very high fixed costs of conducting some types of research. Once a fixed cost is incurred to produce a commodity, society generally benefits the most if the commodity is made available at a price which reflects its marginal cost, which in the case of knowledge is near zero. But, if private research enterprises were to sell the fruits of their research labors at a price of zero, they would never make enough revenue to cover the fixed costs. This disincentive to private allocation mechanisms for research is particularly forceful for “big science” projects which require very large investments in capital equipment and structures, such as state-of-the-art lasers and nuclear particle accelerators. The public sector can overcome these difficulties by raising the revenues for the upfront investments through taxes and by making the results of research freely available to the scientific community.

Uncertainty about whether the gains from a big research project will materialize also creates a disincentive to private investment in research. Even in the pursuit of knowledge which would have tremendous value, any single firm or individual might hesitate to risk the majority of its investment of time or money on a particular research project if the probability of success is quite low. The public sector can accept bigger-risk projects because it pools the resources of society as a whole and will not be threatened by the failure of a single project.

Knowledge as a capital asset

Knowledge also is special when viewed as an asset or investment good. Knowledge is easy to store over long periods of time, and, unlike other commodities, knowledge does not physically depreciate as time progresses. Thus, investments in producing knowledge are likely to have results which are more long-lasting than the capital constructed by other types of investments. Accordingly, the advancement of knowledge has been one of the primary sources of economic growth over long spans of time.

Recent studies of longer-run sources of economic growth also emphasize that the rate of return to research investments likely increases with the cumulative stock of knowledge. The “new growth theory” emphasizes invention as the process of combining validated ideas. Each additional validated idea, or piece of knowledge, greatly increases the number of possible ways in which validated ideas can be combined. Hence, increments to the stock of knowledge can exhibit, over time, even higher rates of return.

Spillover effects of industrial research

Even when there is private investment in research, it can be difficult for private firms to appropriate fully the intellectual property rights to their research results. Some applied research discovers product and process improvements that “spill over” to other firms which can “free-ride” on the discoveries. The presence of these benefits external to the discovering firm, or “externalities,” increases the social rate of return to the research investment without increasing the private rate of return. In such cases, society at large can be made better off by lowering the cost of conducting the research, thus narrowing the gap between social and private rates of return.

To attempt to narrow this gap, the federal tax laws have included since 1981 some form of research tax credit. However, this credit is limited in scope. Also, the research credit is not a permanent feature of the tax code, but rather has been strung along in a series of temporary measures.

Beyond any overall tax system biases against investments made by corporations, the special case for a research tax credit hinges on the extent of spillover effects from industrial research. These are very difficult to quantify. Only indirect estimates of the extent of spillovers are available.

Most estimates of the extent of spillovers rely on studying the differences between the effects of research and development (R&D) spending on the productivity of the firms conducting the research and on the productivity of all firms which could benefit from the research, either directly or indirectly. Studies using this type of method suggest that the private annual rate of return to R&D investments tends to be about 20-30%, whereas social rates of return run in the 20-100% range, with an average of approximately 50% (National Science Board 1996 and Nadiri 1993). Although these estimates are quite imprecise and do not imply that any given research project will generate such high social returns, there is widespread agreement among experts that the social rate of return to industrial research is quite high, on average.

Industrial innovations arising from academic research

The spillovers to industrial applications arise both from privately conducted industrial research at other firms and from academic research, which is usually conducted at universities and publicly funded research labs. A recent survey (Mansfield 1996) indicates that about 10% of the new products and processes developed by industry could not have been developed without recent advances in academic research. The rate of spillover of critical knowledge from academia to industry was particularly high for the information processing and pharmaceuticals industries.

Other types of evidence also corroborate this portrait of frequent spillovers from academic research to industrial applications. For example, in recent years about 36% of all patent applications by private industry cited on their first page a scientific or technical article published by a researcher from an academic institution (National Science Board 1996, p. 5-39). In some cases, these spillovers of academic research are most potent in geographic areas around major universities. For example, Jaffe (1986) found a significant positive relationship between industrial patents and university research conducted on the same topic in the same state.

The difficulty of measuring rates of return to publicly funded research

Undoubtedly, the debate over whether federal funding for the conduct of research and development should decrease or increase from current levels will continue, owing, in part, to the difficulty of measuring the overall social rate of return to publicly funded research. Quantifying the rate of return on investments in research is particularly difficult for those types of basic research whose impact is spread over many years. Adams (1990) emphasized that the pace of learning by scientific personnel is an important determinant of the duration of this lag and found that often there is an extensive delay between an advance of scientific knowledge and its contribution to economic growth. Evaluation of benefits also is difficult for basic scientific and applied research needed to develop some public goods, such as national defense and energy infrastructure products, like nuclear technology. By its very nature, this type of research inexorably alters the course of history, greatly affecting not only the economy, but also many individual lives and the evolution of political systems and the environment. Standard economic methods are incapable of evaluating the net benefits of such research.

Summary

The economics literature has identified a number of reasons for public support of research. Basic knowledge has the classic public good characteristics of being able to be used by many individuals simultaneously and being difficult to appropriate for exclusive use. Although the advancement of knowledge has been one of the primary sources of overall economic growth over long spans of time, the costs of producing basic knowledge tend to be too high relative to risk-adjusted returns for private firms to sponsor enough basic research individually.

Applied research also suffers from incentive problems in a fully privatized market system. Product and process improvements made by one firm can “spill over” to other firms which can “free-ride” on the discoveries. Furthermore, private markets tend not to promote academic research, even though such research has broader social benefits and can lead to industrial applications not originally envisioned.

Joe Mattey
Research Officer

References

Adams, J.D. 1990. “Fundamental Stocks of Knowledge and Productivity Growth.” Journal of Political Economy 98(4) pp. 673-702.

Jaffe, A. 1986. “Technological Opportunity and Spillovers of R&D: Evidence from Firms’ Patents, Profits, and Market Value.” American Economic Review 79(5) pp. 957-970.

Mansfield, Edwin. 1996. “Microeconomic Policy and Technological Change.” In FRB Boston Conference Series 40, Technology and Growth (June).

Nadiri, M.I. 1993. “Innovations and Technological Spillovers.” Working Paper No. 4423. Cambridge, MA: National Bureau of Economic Research.

National Science Board. 1996. Science & Engineering Indicators-1996. Washington, D.C.: U.S. Government Printing Office.

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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