FRBSF Economic Letter
98-16; May 15, 1998
Reasons for Public Support of Research and Development
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.
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
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
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
Spillover effects of industrial
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
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.
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.
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
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 this newsletter 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. Editorial
comments may be addressed to the editor or to the author. Mail comments
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120