Innovation Levers

Innovation is terribly important; it is why we are rich.  We know innovation is caused by economic activity, but if we knew which activities more promoted innovation, we’d want to subsidize them.  Three recent papers suggests we should prefer many small industries each dominated by a few firms, and prefer private research in processes of capital intensive industries, especially chem/drug and comp/electronics.

First, a review article says R&D spending is more effective for process over product, private over public, and basic over applied:

A distinction is made between R&D directed toward invention of new methods of production (process R&D) and R&D directed towards the creation of new and improved goods (product R&D). … Most studies find a higher rate of return for process as compared to product R&D.  … A lower rate of return (or a less significant one) is reported by many authors to public rather than private R&D, both at the private and social level … A higher return is also generally reported on basic R&D as opposed to applied or development. … Social returns, these are almost always estimated to be substantially greater than the private returns.

Second, it seems that larger firms are just less efficient at research, especially in drugs and electronics:

While the empirical literature fails to generate a consensus view, a number of studies report that the patent yield from R&D expenditures falls with firm size.

Third, Shawn Miller, a student in my I/O class last semester, did a great paper predicting patents by industry.  He found more (patent) innovation in industries that are smaller, more capital intensive, and more concentrated among a few firms.  Chemical, computer, drug, and electronic industries were especially innovative.  Here is Miller’s main table:


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  • I have a question. These studies seem to show that patent quantity is interchangeable with patent quality, where patent quality is measured by citations. To get a more direct measure of the impact patents have on economic growth, why isn’t the quality of a patent instead measured by the revenue it generates for a company?

  • gwern

    > He found more patents in industries that are smaller, more capital intensive, and more concentrated among a few firms. Chemical, computer, drug, and electronic industries were especially active in patenting.

    FYPFY. I would *strongly* question that patents=innovation, especially in computing.

    • That was my immediate thought, but the research seems to show that on the whole, patents=innovation. I assume there would be a long tail distribution of patent quality, where a few patents get cited massively and make a huge amount of money, while most don’t get cited at all and actually lose money.

      P.S. There’s that separate argument that I hear from time to time that the software industry is now stifling innovation with their use of patents. Does someone a link to any research on that?

  • Number of patents has much more to do with what legal departments of competing companies are doing than their R&D. As behaviour of legal departments is highly dependent on money and number of competitors involved, I bet it simply swamps out any information on actual innovation.

  • aram

    Here is a toy model. Every firm makes one product (Coke, RC cola, kosher grape juice, etc…) of varying popularity and quality. Each firm has exactly one patent. But their size is different. Their R&D expenses are also different: producing the Coke patent took tons of research, even though there is just one patent filing. (Ok, really it’s a trade secret, but the same principle applies.) It doesn’t even have to be a broad patent; e.g. it can cover Coke, but not Pepsi or Diet Coke. But tons of research went into figuring out the formula.

    I’m not saying this model is right, but it’s one in which large firms are no less effiicent (because gains from variety are offset by the popular drinks being preferred by more people) and yet would generate the same regression results as those papers.

  • jonathan

    This argument agrees with traditional analysis. I don’t see the bias to be overcome here, though the point is always interesting. I can’t remember where it is, but there is work that looks at the quality of patents and finds that the most distinctive ones with the most impact are generated by smaller companies. (Which are then bought.) An anecdotal example is the multi-touch gesturing developed by a company that Apple bought a few years ago.

    One can’t look solely at generation of innovation because innovation needs capital, etc. to come to market. The British invented penicillin but their system then sucked at commercialization and they had to bring it here – literally in pants pockets – for that. A small company can invent multi-touch but that becomes part of devices because a company like Apple – or Cisco or IBM – buys it or the rights.

  • Robert Koslover

    Robin, we already subsidize plenty of innovation by small businesses! Check out the US Govt’s numerous Small Business Innovation Research (SBIR) programs at: and the links therein! Decisions to award or reject SBIR proposals are heavily-based on the reviewers’ assessments of the innovation in the work proposed, the track records of the people proposing it, and their likelihood (in the views of the reviewers) of someday reaching commercial success. And unlike many Govt-funded R&D contracts, SBIR contracts allow the small business in question to keep the intellectual property rights to commercialize the technologies they develop. And there is also the companion STTR program, that is dedicated to encouraging (and funding) teaming between small businesses and universities (and other federally-funded R&D centers), to do technology transfer to industry.

  • Buck Farmer

    For the big vs. small company result:

    Could it be that big companies have more capital, their managers believe they need to deploy that capital instead of returning it to capital providers (thus preserving their empires), and so they are willing to invest in lower ROI research programs in order to use up all that capital?

    Alternatively, could it just be survivorship bias? Assume all units of investment are randomly assigned to research projects, but that failed research projects in big firms receive a second unit of investment while failed research projects in small firms kill the firm.

  • Yes of course patents aren’t a perfect measure of innovation; we often study what we can see more easily.

    • Buck Farmer

      We shouldn’t be like the drunk looking for his keys by the streetlight ’cause it’s brighter there.

      Does no. of citations serve as a better measure of innovation? Do these relationships hold up with that kind of measure?

      Even better one of those network-sensitive measures of citation centrality (not sure the technical term, but if you’re cited in patents or papers that have more citations you’re higher than those with the same no. of citations but fewer second order citations and so on.)

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  • Very interesting post. Unfortunately, since 2000 we have passed a number of laws and regulations that are killing innovation in the US. The incredible innovation of the 90s was based on technology start-up companies built on intellectual capital, financial capital, and human capital. All three of the pillars have been under attack since 2000. Our patent laws have been weakened reducing the value of intellectual capital. Sarbanes Oxley has made it impossible to go public reducing financial capital for start-ups and the FASB rules on stock options have made it harder to attract human capital to start-ups. The Decline and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation, explains these problems in more detail.

  • Constant

    Innovation is terribly important; it is why we are rich. We know innovation is caused by economic activity, but if we knew which activities more promoted innovation, we’d want to subsidize them.

    Subsidizing art seems to have made it ugly. Subsidizing agriculture seems to have made it harm human health (diet too rich in sugars). Subsidizing the purchase of homes seems to have made it cause a financial calamity.

    These were all good things, turned bad by subsidy.

  • Bill

    Mike Scherer has also found this to be the case (former FTC Chief economist).

    Some of Scherer’s other work also involved the characteristics of innovative firm management: if the CEO was an engineer or technical person, there was a greater rate of innovation as compared to a CFO MBA type. Surprisingly, lawyers as CEOs did well too. Number crunchers were more conservative and less understanding of innovation risk/rewards.

  • CJ

    What’s the distinction between basic R&D vs. applied/development R&D? There are many cases I can think of where I don’t know how to draw that distinction, but my experience is limited to academic settings. Can anyone clear up what is probably meant?

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