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Commentary By Charles Hughes

Some Firms Still Gain from R&D

Economics Regulatory Policy

Companies are getting lower returns for the resources they pour into research and development. Across industries, innovation is one of the main ways companies grow, and these discoveries deliver tangible benefits to individuals and the economy as a whole.

Why has the rate of return fallen? Is it that companies have made poor investments?. Or, even worse, have returns to all innovation declined?

Professor Anne Marie Knott of the Olin Business School from Washington University in St. Louis, in a new paper, suggests that returns in some industries have declined, dragging down companies’ average return to research and development investment. Fortunately, companies can diversify their research and development investments into other areas if their current industry has limited opportunity. Companies adept at shifting research and development investment to more promising areas have been able to push the maximum returns to new heights even as the average has fallen.

Innovation overall has not become more difficult. While the prospects for some industries have gotten worse, companies can still uncover opportunities in other areas or even generate entirely new markets through research and development.

Data show that reductions in the inputs do not seem to be the culprit. The number of R&D personnel has increased over time, while total R&D investment has risen modestly as a share of GDP.

Sources: OECD

Some shift has occurred in the composition of R&D investment. The growth in funding by private industries has far outpaced the growth in government funding, so companies have accounted for a growing share of the total over time. The greater role for companies could have implications for the rate of innovation if their returns to research have declined over time.

Innovation as a whole could be getting harder for different reasons. The first, and most prevalent, theory is that the nature of innovation has changed, because developed countries like the United States have already discovered and adopted the major, easy-to-find innovations. The supply of low-hanging fruit fueled a century of growth and prosperity that would have been difficult to imagine before then, but the fruit has now been eaten.

A second theory is that research has diminishing returns, so even though the resources directed to it have not fallen, the return on those inputs has fallen. This could be because they are focused on marginal improvements to existing products or bogged down in projects that are duplicative.

Other headwinds for innovation and economic growth identified by Robert Gordon, professor of social sciences at Northwestern University, include the end of a one-time demographic dividend last century and a plateau in educational attainment.

Professor Knott calls these theories plausible, as her calculation of companies’ research quotient, (a metric she developed to measure the return to innovation inputs) has fallen by 65 percent over the past three decades. This is a startling trend, but it could be happening because innovation overall is getting harder, or because companies are having trouble generating returns on their R&D investments.

Dr. Knott makes a compelling case that it is the latter. Although it may not be intuitive, this is an optimistic diagnosis, because it means some companies have devised ways to get high returns on their innovation investments, and others could figure it out in the future.

If innovation had gotten uniformly harder, not only would the average return be falling, but so would the maximum return. A divergence between some select companies that have been able to maintain or even increase their rates of return to research and development would undercut the pessimistic theory that it has uniformly gotten harder.

Professor Knott finds that the maximum research quotient has actually been increasing over time. Higher maximums could mask differences between industries: if one unicorn technology firm is able to increase maximum returns but every other industry is faltering, the scenario is hardly distinguishable from the pessimistic scenario outlined above.

Fortunately, the same pattern she identified when analyzing all public firms held when she narrowed her range of analysis to industries. At more granular levels, however, she did find that the maximum return decreased over time. 

Source: Anne Marie Knott, Harvard Business Review.

Companies can respond to worsening prospects within a narrow industry by shifting to areas with more opportunity. Knott gives the example of landlines being replaced by cell phones and eventually smartphones. While the market for landlines shrunk, the new market created by the development of new technologies ended up being far greater in the long-run. With the ability to adapt, companies are not resigned to the same fate as the specific industries they operate in at the time.

On average, companies are getting lower returns for their research and development investments. While falling average returns for companies seems like a bleak story, it is actually far better than the alternative: that all of the low-hanging fruit has been picked and innovation will only continue to get harder. Thriving companies have been able to increase their returns even as the average has fallen. This goes against the argument that innovation overall has gotten more difficult--it just has for some companies. Firms that are able to allocate investment to the most promising areas and shift away from fading industries will be better able to generate these higher returns to R&D investment.  

Firms in industries with limited opportunity could create new markets or switch over to new industries with more room to grow, boosting their return on R&D investment and bringing new ideas to the economy. If policies constrain their ability to respond to evolving R&D opportunities the potential return many of them can hope for will fall. In some instances, outright bans deter investment, such as the FAA’s 1973 ban on overland supersonic flight. In others such as autonomous vehicles, requirements to get prior approval from state or local regulators to test products slow the rate of progress. Some companies might respond to more limited returns by reducing the inputs they are willing to dedicate to research and development.

Policymakers should resist this rush to regulate, and give companies the room to adapt to a changing research and development landscape.

Charles Hughes is a policy analyst at the Manhattan Institute. Follow him on twitter @CharlesHHughes

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