the economics of science and technology · cisely these issues that may be most critical in...

The Economics of Science and Technology

David B. Audretsch1

Barry Bozeman2

Kathryn L. Combs3

Maryann Feldman4

Albert N. Link5

Donald S. Siegel6

Paula Stephan7

Gregory Tassey8

Charles Wessner9

ABSTRACT. This paper provides a non-technical, accessibleintroduction to various topics in the burgeoning literature onthe economics of science and technology. This is an interdisci-plinary literature, drawing on the work of scholars in the fieldsof economics, public policy, sociology and management. Theaim of this paper is to foster a deeper appreciation of the eco-nomic importance of science and technology issues. We alsohope to stimulate additional research on these topics.

JEL Classification: O3

1. Introduction

Science and technology have long been regardedas important determinants of economic growth.Edwin Mansfield (1971, pp. 1–2), a pioneer in theeconomics of technological change, noted:

Technological change is an important, if not the mostimportant, factor responsible for economic growth � � �without question, [it] is one of the most important determi-nants of the shape and evolution of the American economy.

1Indiana University2Georgia Institute of Technology3University of St. Thomas4Johns Hopkins University5University of North Carolina at GreensboroGreensboro, NC 27402E-mail: [email protected] of Nottingham and Rensselaer Polytechnic Institute7Georgia State University8National Institute of Standards and Technology9National Academy of Sciences

Science and technology policy are even moreimportant in the “new” economy, with its greateremphasis on the role of intellectual property andknowledge transfer. Thus, it is unfortunate thatmost individuals rarely have the opportunity tostudy this subject. As a result, the general pub-lic poorly understands the antecedents and conse-quences of technological change.

It is clear in the report that most Americansare not well-informed about public policy issuesrelating to science and technology. As shown inTable I, individuals rank science and technologypolicy issues relatively high in terms of interest,yet noticeably lower in terms of their self-assessedknowledge about the issues. However, it is pre-cisely these issues that may be most critical indetermining long-run economic growth.

The purpose of this paper is to provide anoverview of salient topics in the economics ofscience and technology. We devote considerableattention to historical and institutional informa-tion concerning these issues, because we believethat an understanding of the current situationdepends to a large extent on an understanding ofhow this literature and the institutions that sup-port science and technology evolved.1

The remainder of this paper is organized asfollows. Section 2 provides some initial defini-tions. In Section 3, we summarize major pub-lic policy initiatives toward science and technol-ogy in the United States from the colonial periodto the present. Our up-front emphasis on policyunderscores the subtlety of partnerships involvingthe public and private sectors that have emerged

Journal of Technology Transfer, 27, 155–203, 2002©2002 Kluwer Academic Publishers. Manufactured in The Netherlands.

156 Audretsch et al.

Table IIndices of public interest and self-assessed knowledge in

selected policy issues, 1999

Publicinterest Policy issues Informedness

82 New medical discoveries 5371 Environmental pollution 4871 Local school issues 5867 Issues about new scientific

discoveries 4465 Use of new inventions and

technologies 4365 Economic issues and business

conditions 5064 Military and defense policy 4455 Use of nuclear energy to

generate electricity 2953 International and foreign policy 4051 Space exploration 3747 Agricultural and farm issues 33

Source: Science and Engineering Indicators—2000, AppendixTables 8-2 and 8-5.

over the last three centuries. These “public/privatepartnerships” have evolved from government’sdesire to steer private investment towards certaintypes of scientific activity and the developmentand use of new technologies. Thus, the federalgovernment has attempted to establish an environ-ment that is conducive for private sector invest-ment in research and development (R&D), as wellas one in which the public and private sectors canbe partners in undertaking innovative activity.

Section 4 emphasizes the role of technology ineconomic growth and sets the stage for under-standing the scope of science and technology pol-icy mechanisms used to maintain national growth.Fundamental to all such policy instruments isthe relationship among investment in R&D, tech-nological advancement, and economic growth.Dimensions of R&D are described in Section 5.The following section introduces the second partof the primer by emphasizing the entrepreneurialnature of firms, both to innovate and to respond topolicy initiatives. Section 6 advances an economicrationale for government’s role in the innovationprocess. An articulation of such a role has longbeen absent from science and technology policydebates. Having set forth this rationale, four pol-icy mechanisms are discussed from a historical aswell as an economic perspective: patent laws in

Section 7, tax incentives in Section 8, research col-laborations in Section 9, and public/private part-nerships that subsidize research in Sections 10 and11. These mechanisms, and their relationship tofirm behavior, are summarized in Section 12.

All of the policy mechanisms discussed in Sec-tions 7 through 11 are designed to stimulate theprivate sector’s demand for R&D resources. Fordemand mechanisms to be effective there mustalso be a supply response in terms of the edu-cation and increased availability of scientists andengineers. This is the topic of Section 13. As withall public-sector initiatives, there is also an issueof public accountability. How effectively are publicresearch funds being spent? The history of publicaccountability and related evaluation methods aredescribed in Section 14. Section 15 constitutes oursummary statement regarding the current state ofthe field of economics of science and technologyand future directions.

2. Fundamental concepts

As in any new field—and we view the economicsof science and technology as an emerging field thatdraws on concepts from numerous disciplines—there are several fundamental concepts. Thus, webegin with several definitions.

In everyday conversation, terms such as scienceand technology, as well as invention and innova-tion, are often used interchangeably. However, foracademics and policymakers there are importantdistinctions that give each of these terms a uniquemeaning.

Science, in a broad sense, is the search forknowledge, and that search is based on observedfacts and truths. Thus, science begins with knownstarting conditions and searches for unknownend results (Nightingale, 1998). Technology is theapplication of new knowledge learned throughscience to some practical problem. Technologicalchange is the rate at which new knowledge is dif-fused and put into use in the economy.

Closely related to science and technology arethe concepts of invention and innovation. Follow-ing Bozeman and Link (1983, p. 4):

The concepts commonly used in connection with innovationare deceptively simple. Invention is the creation of some-thing new. An invention becomes an innovation when it isput in use.

The Economics of Science and Technology 157

Innovations may be new products, new processes,or new organizational methods that are novel andadd value to economic activity. Thus, inventionparallels the concept of science and innovationparallels the concept of technology.

It is useful to think of an innovation as some-thing new that has been brought into use. Thus,this innovation represents, in a sense, a newunderlying technology.2 Embedded in this distinc-tion between invention and innovation is a processwhereby inventions become applied. This pro-cess is central to what we call entrepreneurship.Entrepreneurship is a process involving the organi-zation of resources, and the output of that processis an innovation.3 Of course, for entrepreneurshipto have economic value the resultant output orinnovation must have economic value.

From an economic perspective, the conceptof entrepreneurial innovation can be traced backto the Physiocrats in France in the mid-1700s.Baudeau (1910, p. 46) referred to a processguided by an active agent, which he called anentrepreneur, within a capitalistic system4:

Such is the goal of the grand productive enterprises: firstto increase the harvest by two, three, four, ten times if pos-sible; secondly to reduce the amount of labor employedand so reduce costs by a half, a third, a fourth, or a tenth,whatever possible.

Embedded in this conceptualization of entrepre-neurship is the notion of an innovative process,one perhaps as simple as the perception of newtechnology adopted from others so as to increaseagricultural yield, or one as refined as the actualdevelopment of a new technology to do the same.When the process is completed, and when theinnovation is put into use, there will be an increasein productivity, and possibly, substitution of capi-tal for labor.

We have defined entrepreneurship as a process:an output is the promotion of one’s own inno-vation or the adoption of another’s innovation.The term entrepreneurship is commonly used torefer to a businessman or even to a risk taker.We use the term entrepreneur in a much broadersense; an entrepreneur is one who perceives anopportunity and has the ability to act upon it.Hence, entrepreneurship is a process that involvesboth perception and action. The perception ofthe opportunity may be influenced by changes instrategic directions or competitive markets, but

perception of the opportunity is the fundamentalfirst step. The consequent step is the ability to acton that perception. What defines the entrepreneuris the ability to move technology forward intoinnovation. The technology may be discovered ordeveloped by others. The entrepreneur is able torecognize the commercial potential of the inven-tion and organize the capital, talent, and otherresources that turn an invention into a commer-cially viable innovation.

What are the requisite resources needed foraction, which takes the perception of an opportu-nity forward to result in an innovation? One obvi-ous answer is research and development (R&D),that is, the commitment of resources to inven-tion and innovation. R&D not only provides astock of knowledge to encourage perception butalso the ability for the firm to foster action. How-ever, firms that do not conduct R&D can still beentrepreneurial, as discussed above. In such firms,innovations are likely to be introduced rather thanproduced. Such firms act in an entrepreneurialmanner by hiring creative individuals and provid-ing them with an environment conducive for theblossoming of their talents.

Consider R&D-active firms. The R&D theyconduct serves two general purposes. First, it pro-vides the resource base from which the firm canrespond to an opportunity with perceived strate-gic merit or technical opportunity that allows thefirm to develop a commercial market. Second,those scientists involved in R&D are the inter-nal resource that facilitates the firm’s being ableto make decisions regarding the technical meritsof others’ innovations and how effectively thoseinnovations will interface with the existing tech-nological environment of the firm. The firm maychoose to purchase or license this technology orundertake a new R&D endeavor. In this lattersense, one important role of R&D is to enhancethe absorptive capacity of the firm.5

Thus, the role of R&D in enhancing theabsorptive capacity of the firm goes beyond simplyassessing the technical merits of potentially pur-chasable technology. It allows the firm to interpretthe extant technical literature, to interface whennecessary with the research laboratories of oth-ers, in a research partnership relationship, or toacquire technical explanations from, say, a federallaboratory or university laboratory; or simply tosolve internal technical problems.


Strategic direction of the firm

Entrepreneurial response Innovation Value Added Competitive market conditions

Figure 1. The entrepreneurial process: an initial look.

Figure 1 provides an initial view of what weterm the entrepreneurial process. This initial anal-ysis will be expanded upon, but here it introducesthe following concepts:

• The organization, typically a private firm, has afocus that results from its agreed upon strate-gic direction. This strategic direction, coupledwith competitive market conditions, generatesan entrepreneurial response.

• The purposive activity associated with theentrepreneurial response leads to an innova-tion.

• There are market forces at work that are, inpart, beyond the influence of the firm andthese forces determine the economic value ofthe innovation and hence the value added tothe project as well as to the user of the inno-vation.

There is a subtle distinction between entrepre-neurship or the innovation process and the processof science and discovery. As noted above, sciencemoves from starting conditions toward unknownresults whereas the innovation process starts withan anticipated intended result and moves towardthe unknown starting conditions that will pro-duce it.

3. Historical background6

The history of science, technology, and economicgrowth in the United States was greatly influencedby the scientific discoveries and university infras-tructure within Europe at the time of colonization.While difficult to pinpoint how or which specificelements of scientific and technical knowledge dif-fused across the Atlantic, certain milestone eventscan be dated and pivotal individuals can be sin-gled out. This background gives us an appreciationfor the role that science and technology resourcesplayed in the developing American nation andcontributed to shaping the preeminent role thatthe former colony achieved.

An understanding of these historical eventsand players is important because it allows one tounderstand the environment in which innovationtakes place and the genesis of the assumptionsthat underlie the public policies that influence thisenvironment. It also illustrates the evolving rolethat the government has taken in promoting sci-ence and technology.

The colonial period

The first member of the Royal Society of Londonto immigrate to the Massachusetts Bay Colonywas John Winthrop, Jr. in 1631, just a few yearsafter the founding of the Colony. As a scientist,he is credited with establishing druggist shops andchemistry laboratories in the surrounding villagesto meet the demand for medicine. According toUNESCO (1968, p. 9), these ventures were “per-haps the first science based commercial enterpriseof the New World.”

Before the turn of the eighteenth century,colonists made noticeable advances toward whatmay be called a scientific society, organizing sci-entists who came from England and other Euro-pean countries into communities that promotedscientific inquiry. In 1683, the Boston Philosoph-ical Society was formed to advance knowledge inphilosophy and natural history. Benjamin Franklinformed the American Philosophical Society ofPhiladelphia in 1742 to encourage correspon-dence with colonists in all areas of science. Itlater merged with the Franklin-created AmericanSociety to promote what Franklin called “use-ful knowledge,” and it still exists today. Thiscombined Society focused on making availableadvancements in agriculture and medicine to allindividuals by sponsoring the first medical schoolin America (also supported by the Pennsylva-nia House of Representatives). Thus, Franklin’sSociety was a hallmark of how public and privatesector interests could work together for the com-mon weal.7

Influenced by the actions of Pennsylvania andlater Massachusetts with regard to sponsorship ofscientific institutions, the establishment of nationaluniversities for the promotion of science wasfirst discussed at the Constitutional Conventionin 1787. However, at that time the founders of


the Constitution believed educational and scien-tific activities should be independent of directnational governmental control. But, they felt thatthe national government should remain an influ-ential force exerting its influence through indirectrather than direct means. For example, Article I,Section 8, of the Constitution permits the enact-ment of patent law:

The Congress shall have the power � � � To promote theprogress of science and useful arts, by securing for limitedtimes to authors and inventors the exclusive right to theirrespective writings and discoveries.8

However, Thomas Jefferson championed amore direct role for the government in the areaof science. While president, Jefferson sponsoredthe Lewis and Clark expedition in 1803 to advancethe geographic knowledge of the nation, thus mak-ing clear that “the promotion of the general wel-fare depended heavily upon advances in scientificknowledge” (UNESCO, 1968, p. 11). In fact, thisaction by Jefferson set several important prece-dents including the provision of federal funds toindividuals for scientific endeavors.

Although the Constitution did not set forthmechanisms for establishing national academicinstitutions based on the founders’ belief that thegovernment should have only an indirect influenceon science and technical advancement, the needfor a national institution related to science andtechnology was recognized soon after the Revolu-tionary War. For example, West Point was foundedin 1802 as the first national institution of a sci-entific and technical nature, although Connecticutestablished the first State Academy of Arts andSciences in 1799.

In the early 1800s, universities began to empha-size science and technical studies, and in 1824Rensselaer Polytechnic Institute was founded inNew York State to emphasize the application ofscience and technology. The American Journal ofScience was the first American scientific publica-tion, followed in 1826 by the American MechanicsMagazine.

The social importance of the government hav-ing a direct role in the creation and applicationof technical knowledge was emphatically demon-strated in the 1820s and 1830s through its supportof efforts to control the cholera epidemic of 1822.Also during that time period federal initiatives

were directed toward manufacturing and trans-portation. In fact, the Secretary of the Treasury—the Department of the Treasury being the moststructured executive department at that time—directly funded the Franklin Institute in Philadel-phia to investigate the causes of these problems.This action, driven by public concern as well asthe need to develop new technical knowledge, wasthe first instance of the government sponsoringresearch in a private-sector organization.

In 1838, the federal government again took alead in the sponsorship of a technological innova-tion that had public benefits. After Samuel Morsedemonstrated the feasibility of the electric tele-graph, Congress provided him with $30,000 tobuild an experimental line between Baltimore,Maryland, and Washington, DC. This venture wasthe first instance of governmental support to a pri-vate researcher.9

Public/private research relationships continuedto evolve in frequency and in scope. In 1829,James Smithson, gifted $500,000 to the UnitedStates to found an institution in Washington,DC for the purpose of “increasing and diffusingknowledge among men” (UNESCO, 1968, p. 12).Using the Smithson gift as seed funding, Congresschartered the Smithsonian Institution in 1846, andJoseph Henry became its first Executive Officer.Henry, a renowned experimental physicist, contin-ued the precedence of a federal agency directlysupporting research through grants to individ-ual investigators to pursue fundamental research.Also, the Institution represented a base for exter-nal support of scientific and engineering researchsince, during the 1850s, about 100 academic insti-tutions were established with science and engi-neering emphases.

Thus, the pendulum had made one completeswing in the hundred years since the signing of theConstitution. In the early years, the governmentviewed itself as having no more than an indirectinfluence on the development of science and tech-nology, but over time its role changed from indi-rect to direct. This change was justified in largepart because advances in science and technologyare viewed as promoting the public interest.

Toward a national infrastructure

Scientists had long looked toward the Europeanuniversities for training in the sciences, but now an


academic infrastructure was beginning to developin the United States. Harvard University awardedits first bachelor of science degree in 1850. Thedevelopment of an academic science base and thebirth of technology-based industries (e.g., the elec-trical industry) in the late 1850s established whatwould become the foundation for America’s tech-nological preeminence.

In 1863, during the Civil War, Congress estab-lished the National Academy of Sciences. The fed-eral government funded the Academy but not themembers affiliated with it who had “an obligationto investigate, examine, experiment, and reportupon any subject of science or art in response to arequest from any department of the Government”(UNESCO, 1968, p. 14). Then, as today, theAcademy is independent of governmental control.

The Morrill Act of 1862 established the landgrant college system thereby formally recognizingthe importance of trained individuals in the agri-cultural sciences. The Act charged each state toestablish at least one college in the agriculturaland mechanical sciences. Each state was given30,000 acres of federal land per each elected U.S.Senator and Representative. An important out-growth of this land grant system was a mechanismor infrastructure through which state and federalgovernments could financially support academicresearch interests.

Although the federal government was encour-aging an infrastructure to support science andtechnical research, it did not have a so-called in-house staff of permanent professionals who werecompetent to identify either areas of nationalimportance or areas of importance to specificagencies. In 1884, Congress established the Alli-son Commission to consider this specific issue.While many solutions were debated, including theestablishment of a Department of Science—anidea that resurfaces every few decades—the Com-mission soon disbanded without making any rec-ommendations much less reaching closure on thematter. One could conclude from the inaction ofthe Commission that it favored the decentralizedadministrative architecture that had evolved overtime as opposed to a centralized one.

Toward an industrial infrastructure

Most scientists in the United States in the 1870sand 1880s had been trained in Europe, Germany

in particular. What they experienced firsthandwere the strong ties between European industriesand graduate institutions. European companiesinvested in professors and in their graduate stu-dents by providing them with funds and accessto expensive materials and instruments. In return,the firms gained lead-time toward new discover-ies, as well as early access to the brightest grad-uate students as soon as they completed theirstudies.10 This form of symbiotic arrangementbecame the norm for the European-trained scien-tists who were working in U.S. industries and U.S.universities.

By the turn of the century, it was widelyaccepted among industrial leaders that scientificknowledge was the basis for engineering develop-ment and was the key to remaining competitive.Accordingly, industrial research laboratories soonbegan to blossom as companies realized their needto foster scientific knowledge outside of the uni-versity setting.11 There are a number of examplesof this strategy.

General Electric (GE) established the GeneralElectric Research Laboratory in 1900 in responseto competitive fears that improved gas lightingwould adversely affect the electric light business,and that other electric companies would threatenGE’s market share as soon as the Edison patentsexpired. Similarly, AT&T was facing increasingcompetition from radio technology at the sametime. In response, AT&T established Bell Labo-ratories to research new technology in the eventthat wire communications were ever challenged.And as a final example, Kodak realized at theturn of the century that it must diversify from syn-thetic dyes. For a number of years Kodak relied onGerman chemical technology, but when that tech-nology began to spill over into other areas suchas photographic chemicals and film, Kodak real-ized that their competitive long-term health restedon their staying ahead of their rivals. Kodak tooformed an in-house research laboratory.

Many smaller firms also realized the compet-itive threats that they could potentially face as aresult of technological competition, but because oftheir size they could not afford an in-house facility.So as a market response, contract research labo-ratories began to form. Arthur D. Little was onesuch contract research laboratory that specializedin the area of chemicals.


Just as industrial laboratories were growingand being perceived by those in both the pub-lic and private sectors as vitally important to theeconomic health of the nation, private founda-tions also began to grow and to support universityresearchers. For example, the Carnegie Institutionof Washington was established in 1902, the Rus-sell Sage Foundation in 1907, and the RockefellerFoundation in 1913.

In the early-1900s science and technologybegan to be embraced—both in concept and inpractice—by the private sector as the founda-tion for long-term competitive survival and gen-eral economic growth.

World War I and the years that followed

Increased pressure on the pace of scientificand technical advancements came at the begin-ning of World War I. The United States hadbeen cut off from its European research base.Congress, in response, established the Council ofNational Defense in 1916 to identify domesticpockets of scientific and technical excellence. TheNational Academy of Sciences recommended toPresident Woodrow Wilson the formation of theNational Research Council to coordinate cooper-ation between the government, industry, and theacademic communities toward common nationalgoals.12 The prosperity of the post-World War Idecade also created an atmosphere supportive ofthe continued support of science and technology.In 1920, there were about 300 industrial researchlaboratories, and by 1930 there were more than1,600.13 Of the estimated 46,000 practicing scien-tists in 1930, about half were at universities andover a third were in industry. Herbert Hoover wasSecretary of Commerce at this time. He adoptedthe philosophy that (UNESCO, 1968, p. 18):

� � � pure and applied scientific research constitute a foun-dation and instrument for the creation of growth and effi-ciency of the economy.

In response to the Great Depression and the sub-sequent national economic crisis, two importantevents occurred in 1933. One was the appoint-ment of a Science Advisory Board and the otherwas the establishment of a National PlanningBoard. Whereas the National Research Councilhad been organized around fields of science to

address governmental needs, the Science Advi-sory Board was multi-field and organized aroundimpending national problems. The National Plan-ning Board was formed on the presumptionthat there were areas of economic concern thatrequired a national perspective rather than afield-of-science perspective. In 1934, the NationalResources Committee replaced the National Plan-ning Board, and it then subsumed the ScienceAdvisory Board. The bottom line was, after all ofthe organizational issues were settled, that the fed-eral government recognized through the forma-tion of these committees and boards that it hadand would continue to have an important coordi-nating role to play in the science and technologyplanning toward a national goal of economic wellbeing. Hence, the pendulum began to swing awayfrom government having a hands-on role toward ithaving an indirect influence on planning the envi-ronment for science and technology.

In 1938, the Science Committee of the NationalResources Committee issued a multi-volumereport entitled, Research—A National Resource.Some important first principles were articulatedin that report. These principles have since thenformed a basis for economists and policy makersto rationalize/justify the role of government in sci-ence and technology. The report is explicit that:

• There are certain fields of science and tech-nology, which the government has a Consti-tutional responsibility to support. These fieldsinclude defense, determination of standards,and certain regulatory functions.

• The government is better equipped to carryon research in certain fields of science thanthe private sector. These are areas where“research is unusually costly in proportion toits monetary return but is of high practicalor social value” (p. 25). Examples cited inthe report include aeronautical and geologicalresearch.

• Research by the government “serves to stimu-late and to catalyze scientific activity by non-governmental agencies. In many fields, newlines of research are expensive and returnsmay be small or long delayed. Industry can-not afford to enter such fields unless there isreasonable prospect of definite financial gainwithin a predictable future, and it is under such


circumstances that the Government may leadthe way � � � ” (p. 26). One example cited wasthe Navy Department’s influence on the devel-opment of the steel industry.

World War II and the years that followed

The involvement of the United States in WorldWar II had a dramatic impact on the scope anddirection of government’s support of science andtechnology. Prior to the war, there were about92,000 scientists, with about 20 percent in govern-ment and the remaining 80 percent being almostequally divided between universities and the morethan 2,200 industrial laboratories. Clearly, theUnited States had a significant scientific resourcebase to draw upon for it war efforts.

In 1940, President Roosevelt established theNational Defense Research Committee and askedVannevar Bush, President of Carnegie Institutionof Washington, to be its chairman. The purposeof this committee was to organize scientific andtechnological resources toward enhancing nationaldefense. It soon became apparent that this taskrequired an alternative administrative structure.In 1941, Roosevelt issued an Executive Orderestablishing the Office of Scientific Research andDevelopment (OSRD) with Bush as Director. TheOSRD did not conduct research; rather it real-ized that there were pockets of scientific andtechnological excellence throughout the country,and through contractual relationships with uni-versities and industry and government agenciesit could harness national strengths with a focuson ending the war. One hallmark event from theefforts of the OSRD was the establishment ofthe Los Alamos Laboratory in New Mexico underthe management of the University of California.What came about from the collective efforts ofthe resources acquired by the Office were not onlyatomic weapons but also radar.

By 1944, it was clear that World War II wasalmost over. President Roosevelt then asked Bushto develop recommendations as to how scien-tific advancements could contribute in the largersense to the advancement of national welfare. Inhis November 17, 1944 letter to Bush, PresidentRoosevelt stated:

The Office of Scientific Research and Development, ofwhich you are the Director, represents a unique experi-ment of team-work and cooperation in coordinating sci-entific research and in applying existing scientific knowl-edge to the solution of the technical problems paramountin war. � � � There is � � � no reason why the lessons to befound in this experiment cannot be profitably employed intimes of peace. This information, the techniques, and theresearch experience developed by the Office of ScientificResearch and Development and by the thousands of scien-tists in the universities and in private industry, should beused in the days of peace ahead for the improvement ofthe national health, the creation of new enterprises bring-ing new jobs, and the betterment of the national standardof living. � � � New frontiers of the mind are before us, andif they are pioneered with the same vision, boldness, anddrive with which we have waged this war we can create afuller and more fruitful employment and a fuller and morefruitful life.

Shortly before asking Bush to prepare thisreport, Senator Kilgore from West Virginia hadintroduced a bill to create a National ScienceFoundation. The Kilgore bill recommended givingauthority to federal laboratories to allocate publicmoneys in support of science to other governmentagencies and to universities. Clearly, this recom-mendation gave a direct role to government inshaping the technological course of the countrynot only in terms of scientific direction but alsoin terms of what groups would conduct the under-lying research. The bill was postponed until afterthe war.

Bush submitted his report, Science—The End-less Frontier, to President Roosevelt on July 25,1945. In Bush’s transmittal letter to the presidenthe stated:

The pioneer spirit is still vigorous within this Nation. Sci-ence offers a largely unexplored hinterland for the pioneerwho has the tools for his task. The reward of such explo-ration both for the Nation and the individual are great.Scientific progress is one essential key to our security asa nation, to our better health, to more jobs, to a higherstandard of living, and to our cultural progress.

The foundations set forth in Science—The End-less Frontier are:

• “Progress � � � depends upon a flow of new sci-entific knowledge” (p. 5).

• “Basic research leads to new knowledge.14 Itprovides scientific capital. � � � New productsand new processes do not appear full-grown.They are founded on new principles and newconceptions, which in turn are painstakingly


developed by research in the purest realms ofscience” (p. 11).

• “The responsibility for the creation of new sci-entific knowledge � � � rests on that small bodyof men and women who understand the fun-damental laws of nature and are skilled in thetechniques of scientific research” (p. 7).

• “A nation which depends upon others for itsnew basic scientific knowledge will be slow inits industrial progress and weak in its compet-itive position in world trade, regardless of itsmechanical skill” (p. 15).

• “The Government should accept new responsi-bilities for promoting the flow of new scientificknowledge and the development of scientifictalent in our youth” (p. 7).

• “If the colleges, universities, and researchinstitutes are to meet the rapidly increas-ing demands of industry and Government fornew scientific knowledge, their basic researchshould be strengthened by use of public funds”(p. 16).

• “Therefore I recommend that a new agency forthese purposes be established” (p. 8).

Bush recommended in his report the creationof a National Research Foundation. Its proposedpurposes were to:

� � � develop and promote a national policy for scien-tific research and scientific education, � � � support basicresearch in nonprofit organizations, � � � develop scientifictalent in American youth by means of scholarships andfellowships, and � � � contract and otherwise support long-range research on military matters.

Bush envisioned a National Research Foun-dation that would provide funds to institutionsoutside government for the conduct of research.Thus, this organization differed from Kilgore’sproposed National Science Foundation in thatBush advocated an indirect role for government.There was agreement throughout government thatan institutional framework for science was needed,but the nature and emphases of that frameworkwould be debated for yet another five years.15

Science—The Endless Frontier affected the sci-entific and technological enterprise of this nationin at least two ways. It laid the basis for whatwas to become the National Science Foundationin 1950. Also, it set forth a paradigm that wouldover time influence the way that policy makers and

academic researchers thought about the processof creating new technology. The so-called linearmodel set forth by Bush is often represented by:

Basic Research→Applied Research→Development→Enhanced Production→Economic Growth

Complementing Science—The Endless Frontierwas a second, and often overlooked, report pre-pared in 1947 by John Steelman, then Chair-man of the President’s Scientific Research Board.As directed by an Executive Order from Pres-ident Truman, Steelman, in Science and PublicPolicy, made recommendations on what the fed-eral government could do to meet the challengeof science and assure the maximum benefits tothe Nation. Steelman recommended that nationalR&D expenditures should increase as rapidly aspossible, citing (p. 13):

1. Need for Basic Research. Much of the world isin chaos. We can no longer rely as we once didupon the basic discoveries of Europe. At thesame time, our stockpile of unexploited funda-mental knowledge is virtually exhausted in cru-cial areas.

2. Prosperity. This Nation is committed to a pol-icy of maintaining full employment and full pro-duction. Most of our frontiers have disappearedand our economy can expand only with moreintensive development of our present resources.Such expansion is unattainable without a stim-ulated and growing research and developmentprogram.

3. International Progress. The economic healthof the world—and the political health of theworld—are both intimately associated with ourown economic health. By strengthening oureconomy through research and development weincrease the chances for international economicwell-being.

4. Increasing Cost of Discovery. The frontiers ofscientific knowledge have been swept so farback that the mere continuation of pre-wargrowth, even in stable dollars, could not possi-bly permit adequate exploration. This requiresmore time, more men, more equipment thanever before in industry.


5. National Security. The unsettled internationalsituation requires that our military researchand development expenditures be maintainedat a high level for the immediate future. Suchexpenditures may be expected to decrease intime, but they will have to remain large for sev-eral years, at least.

An important element of the Steelman reportwas the recommended creation of a National Sci-ence Foundation, similar in focus to the NationalResearch Foundation outlined by Bush. And,Congress passed the National Science FoundationAct in 1950.

Renewed post-war attention toward science andtechnology came with the success of the SovietUnion’s space program and the orbit of its SputnikI in October 1957. In response, President Eisen-hower championed a number of committees andagencies to ensure that the United States couldsoon be at the forefront of this new frontier. Note-worthy was the National Defense Education Actof 1958, which authorized $1 billion in federalmoneys for support of science, mathematics, andtechnology graduate education. This proposal isprecisely the type of support that Bush recom-mended in his report.

As the post-World War II period came to aclose, there was a well-established national andindustrial infrastructure to support the advance-ment of science and technology. But, moreimportant than the infrastructure, there was animbedded belief that scientific and technologi-cal advancements are fundamental for economicgrowth, and that the government has an impor-tant supporting role—both direct and indirect—toensure such growth.

Every president since Eisenhower has initiatedmajor science policy initiatives.16 Kennedy set thegoal of sending a man to the moon by the endof the 1960s and funded the needed programsto make this a reality. Johnson emphasized theuse of scientific knowledge to solve social prob-lems through, for example, his War on Poverty.Nixon dramatically increased federal funding forbiomedical research as part of his War on Cancer.Ford created the Office of Science and Technol-ogy Policy (OSTP) within the Executive Branch.Carter initiated research programs for renewableenergy sources such as solar energy and fission.

During the Reagan administration, expenditureson defense R&D increased dramatically as part ofhis Star Wars system. President Bush (no relation-ship to Vannevar Bush) set forth this nation’s firsttechnology policy (see below) and increased thescope of the National Institute of Standards andTechnology (NIST, see below). President Clintonestablished important links between science andtechnology policy, championing programs to trans-fer public technology to the private sector.

4. Economic growth and technological change

In the previous section, we described VannevarBush’s paradigm of research and developmentleading to economic growth. As a practical mat-ter, economic growth is generally defined at themacroeconomic level in terms of Gross Domes-tic Product (GDP).17 Figure 2 shows GDP-relatedgrowth for a number of countries. GDP per capitais greater in the United States than in any of theother industrial nation shown in the figure.

An inspection of Figure 2 raises a number ofquestions, two of which are: Why do economiesgrow? and, Why has the U.S. economy outper-formed that of other industrial nations even aftercontrolling for national size?

Theories of economic growth

The early literature on economic growth is formu-lated analytically using what economists refer toas a production function. Simply put, a produc-tion function represents the relationship betweenthe output of an economic unit (a firm, industry,or economy) and the factors of production—orinputs or resources—used to produce that output.

0

5

10

15

20

25

30

35

1960 1965 1970 1975 1980 1985 1990 1995 2000

Year

Rea

l GD

P

U.S. Japan France Germany U.K.

Figure 2. Real GDP per capita for selected countries1960–1999 (U.S. $1000). Source: Science and EngineeringIndicators—2000, Appendix Table 7-3.


If output, Q, can be defined in terms of thetwo most basic factors of production, the stock ofcapital (plant and equipment), K, and the stock oflabor, L, then a basic production function can bewritten as:

Q = f �K�L� (1)Equation (1) denotes that a firm’s, industry’s,or economy’s output will change in response tochanges in either the quantity or quality of capi-tal or the quantity or quality of labor. However,to account for other influences on output suchas new technology, the production relationshipin Equation (1) can be modified most simply toinclude a catch-all variable, A, as:

Q = AF�K�L� (2)where, to be more specific, A is a shift factor toaccount for exogenous technological factors (asopposed to conventional factor inputs such as Kand L) that affect production, and where, becauseof the inclusion of A in Equation (2), F�K�L� isdistinct from f �K�L� in Equation (1).

By dividing both sides of Equation (2) by thecombination of K and L inputs (i.e., by total fac-tors) denoted by F�K�L�, variable A can be inter-preted as an index of output per unit of all inputsor of total factor productivity.

A=Q/F�K�L� (3)Early on, Robert Solow (1957), who was sub-

sequently awarded the Nobel Prize in economics,estimated a variation of Equation (3) using aggre-gate U.S. data. He calculated changes in thevalue of A between 1909 and 1949. His analysisshowed that more than 87 percent of the growthin the U.S. economy could not be explained bythe growth in capital and labor, and hence theresidual or unexpected portion of growth must

50

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90

100

110

1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998

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TF

P

Figure 3. Private nonfarm TFP, 1948–1997. Source: U.S.Bureau of Labor Statistics.

be attributable to something else.18 Solow specu-lated that what was captured in his residual calcu-lation may reflect technology advance over time.Changes in A from Equation (3) measure what iscalled total factor productivity growth, or techno-logical advancement.

Other researchers, using alternative frame-works, reached similar conclusions. Abramovitz(1956), for example, referred to the unexplainedportion of growth more cautiously as a measureof our “ignorance.” This implied that whileeconomists were able to calculate unexplainedgrowth, they were unable to provide a con-clusive explanation for what caused improve-ments in economic performance. Unlike Solow,Abramovitz speculated in some detail that growthnot attributable to capital and labor was likelydue to improvements in education and increasesin research and development activity (R&D).

The academic literature is replete with theo-ries to explain growth over time. The so-called“old growth” theory literature (Nelson and Phelps,1966) is based on more sophisticated versions ofEquation (1). That is, this literature emphasizesadditional inputs aside from K and L such asinvestments in R&D and education. As well, itemphasizes the greater specificity by which inputsare measured including consideration for the het-erogeneity of K and L (e.g., new vintages of Kembody others’ technological investments).

The so-called “new growth” theory (Romer,1986, 1994) emphasizes the influence of other fac-tors on growth that are not directly specified inan expanded version of Equation (1). These fac-tors include, for example, technologies or efficien-cies that spillover into a firm’s production functioneither from other firms or from general advancesin the economy (such as information technology)or that spillover into a nation’s production func-tion from trade policies. New growth theory is alsobased on careful, explicit analytical modeling ofthe incentives of agents to invest in new technol-ogy. Figure 4 expands upon Figure 1 to incorpo-rate these ideas. In particular, two new elementsare included in Figure 4 that were not in Figure 1.First, in-house or private investment in R&D isshown to have an influence on how the firmresponds to the interaction of its strategic direc-tion and its competitive environment. Second, wehave capsulated the essence of new growth theory


Strategic direction of the firm

Entrepreneurial response Innovation Value Added Competitive market conditions

In-house R&D External influences on economic performance

Figure 4. The entrepreneurial process: a second look.

by simply acknowledging that external influencesaffect firm performance directly as well as indi-rectly through innovation.

Regardless of whether one adheres to the morenarrow old theories or the broader new theo-ries, the evidence is overwhelming that technologydrives economic growth. There was renewed inter-est in promoting economic growth in the postwaraftermath of the destruction of the industrial baseof many nations. Thus, it is not surprising thatgreater attention was devoted to the analysis ofR&D, which was hypothesized early on to be animportant determinant of economic growth.

5. Dimensions of R&D

For purposes of measurement, there are three fun-damental dimensions of R&D. The first relatesto the source of funding of R&D (who financesR&D), the second to the performance of R&D(who actually does the work), and the third tothe character of use of R&D (whether the workis basic research, applied research, or develop-ment). These three fundamental dimensions arenot mutually exclusive.

Table IINational R&D expenditures, by performer and funding source: 1999 ($millions)

Source of R&D funds

Other PercentFederal Universities Non-federal nonprofit distribution,

Performer government Industry and colleges government institutions Total by performer

Total R&D 65�853 169�312 5�838 2�085 3�912 247�000 1000%Federal government 17�362 — — — — 17�362 70%Industry 19�937 165�955 — — — 185�892 753%Industry FFRDCs 2�166 — — — — 2�166 09%Universities and colleges 16�137 2�163 5�838 2�085 2�032 28�255 114%University FFRDCs 6�169 — — — — 6�169 25%Other nonprofit institutions 3�246 1�194 — — 1�880 6�320 26%Nonprofit FFRDCs 836 — — — — 836 03%Percent distribution, by source 26.7% 68.5% 2.4% 0.8% 1.6% 100%

Source: National Science Foundation.

There are also other important aspects ofR&D. One such dimension is related to the sizeof firms that conduct R&D, a second to the geo-graphical distribution of R&D, and a third to therelationship between R&D and total factor pro-ductivity growth. We now consider each of thesedimensions in turn.

Sources of funding of R&D

The top row of Table II shows the sources for the$247.0 billion of R&D expenditures in the UnitedStates in 1999. Industry accounted for nearly 69percent of those expenditures; the federal govern-ment another 27 percent; and all other sources,including state and local governments, universi-ties and colleges, and other nonprofit institutions,about 5 percent.

The primacy of industry in funding R&D hasnot always held, as shown in Figure 5. In theaftermath of World War II up through the early1980s, the federal government was the leadingprovider of R&D funds in the Nation. Althougha federal R&D presence existed before then, dur-ing the war the federal government dramaticallyexpanded its R&D effort by establishing a networkof federal laboratories, including atomic weaponslaboratories. It was at that time that the federalgovernment also greatly increased its support toextramural R&D performers, especially to a selectgroup of universities and large industrial firms.After the war (along with the widespread influence


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1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

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$R&

D

Total Federal Industry

Figure 5. U.S. R&D funding by source, 1953–1998 (bil-lions $1992). Source: Science and Engineering Indicators—2000,Appendix Table 2-6.

of the Bush and Steelman reports), federal R&Dsupport continued to expand for both defense andnon-defense purposes, including health R&D inthe National Institutes of Health and—after theestablishment of the National Science Founda-tion in 1950—a broad portfolio of fundamentalresearch activities. As a result of a post-Sputniknational commitment to catch up to the Sovietspace successes, federal support for space-relatedR&D mushroomed in the late 1950s and early1960s. By 1960, the federal government accountedfor 65 percent of the nation’s total investment(80 percent of which was for defense), and indus-try accounted for 32 percent of the total.

Over the next twenty years the federal govern-ment continued to be the leading source of R&Dfunding, although the direction shifted over time.In the early 1960s, the relative defense share offederal R&D funding dropped precipitously from80 percent in 1960 to about 50 percent in 1965,where it fluctuated narrowly until 1980. Early on,R&D for space exploration was the primary non-defense recipient of federal R&D funding. Indeedmore than three-fourths of federal non-defenseR&D funds were in support of NASA’s missionactivities by 1965. By 1970, however, after the suc-cess of several lunar landings, support for othernon-defense purposes began to claim an increas-ingly larger share of the federal R&D totals, andcontinued to do so throughout the 1970s; notablygrowth in federal energy R&D occurred as aresponse to the several oil embargoes. Also by1970, R&D support from industry was on the rise,and it accounted for just over 40 percent of thetotal national R&D effort. As a result of relativelyflat federal funding in the 1970s and continual

slow growth from the industrial sector, the fed-eral government and industry accounted for aboutequal shares by the early 1980s.

Since then the federal government’s share ofR&D decreased to about 40 percent of totalin 1990 to its current share, somewhat below30 percent. Initially, the decreasing federal sharecame about even though federal dollar supportfor R&D—in absolute terms—was increasing.Between 1980 and 1987, federal R&D rose about40 percent after adjusting for inflation. Most ofthis growth, however, was in support of defenseactivities so that by 1987, the defense R&D sharehad grown to two-thirds of the federal R&D total(its highest share since 1963). After the break-upof the Soviet Union, the imperative for continualgrowth in federal defense R&D support was notas strong and the federal R&D total once againslowed (and even fell in constant dollars).

In terms of which agencies provide the R&Dfunds, federal sources are highly concentratedamong just a few agencies. According to the latestdata provided by the agencies themselves, of the$74 billion obligated for R&D and R&D plant infiscal year 1998, just five accounted for 94 per-cent of all funds: Department of Defense (48%),Department of Health and Human Services, pri-marily the National Institutes of Health (19%),National Aeronautics and Space Administration(13%), Department of Energy (9%), and NationalScience Foundation (3%).

Concurrent with recent reductions in federalR&D spending, major changes have also occurredin industrial R&D spending patterns. After lack-luster funding in the early 1990s (reflecting theimpact of mild recessions on its R&D activities)industry R&D support has grown rapidly since1994 and now accounts for almost 70 percent ofthe national R&D total. As a result, and comparedwith the funding patterns of the mid-1960s, indus-try and government have reversed positions.

R&D performers

R&D is performed in what has been termed theU.S. national innovation system. The system is,according to Crow and Bozeman (1998, p. 42):

� � � the complex network of agents, policies, and institu-tions supporting the process of technical advance in aneconomy.


The performers of R&D within the system areresearch laboratories. The laboratory performersof R&D correspond to the sectors that financeR&D, but not all R&D funded by a sector isperformed in that sector. For example, industryperformed approximately $186 billion of R&D in1999, of which $166 billion came from industryitself. The additional amount of R&D performedby industry came from the federal government.

Almost one-third of the R&D funded by thefederal government is performed in industry, andmore than one-half of those dollars are spent inthe aircraft, missiles, and transportation equip-ment industries. Universities and colleges fundonly about 20 percent of the R&D they perform.Fifty-seven percent of the R&D performed inuniversities and colleges comes from the federalgovernment and the rest equally from industry,nonprofit institutions, and nonfederal governmentsources.

As shown in Figure 5, since the late-1980sthe federal government has decreased its fund-ing of national R&D. The lion’s share of thatdecrease has come in the form of federal alloca-tions for R&D performed in industry, for whichthe R&D level of support displays a somewhatroller-coaster-like pattern. The latest peak in fed-eral support for industrial R&D was a result ofmajor defense-related funding increases for Presi-dent Reagan’s Strategic Defense Initiative prior tothe collapse of the Soviet Union. By contrast, fed-eral funding to universities and colleges, adjustedfor inflation, has increased slightly each year sinceat least the late 1970s.

There are other important dimensions to theperformance of industrial R&D. About three-fourths of industrial R&D is performed in manu-facturing industries. The dominant manufacturingindustries in terms of dollars of R&D performedare chemicals and allied products, electrical equip-ment (including computers), and transportationequipment. The remaining one-fourth is per-formed in the non-manufacturing sector, includingservices. Computer-related services are the lead-ers therein. The steep growth in R&D performedin the services is a relatively recent phenomenon.As recently as 15 years ago, manufacturers stillaccounted for more than 90 percent of the indus-trial R&D total.

Also, not all industry-performed R&D occurswithin the geographical boundaries of the United

States. Of the nearly $186 billion in R&D per-formed by industry in 1998 (the latest year forwhich the foreign-performed data are available),about $16 million, or about 9 percent, was con-ducted in other countries. Foreign investmentsin R&D are not unique to U.S. firms; the out-flow of U.S. industrial R&D into other countriesis approximately offset by an inflow of others’R&D to be performed in the United States.Most (68 percent) of U.S.-funded R&D abroadwas performed in Europe—primarily in Germany,the United Kingdom, and France. The currentEuropean share of U.S. industry’s offshore R&Dactivity, however, is somewhat less than the 75 per-cent share reported for 1982 (peak year). Overall,U.S. R&D investments abroad have generallyshifted away from the larger European coun-tries and Canada, and toward Japan, several ofthe smaller European countries (notably Swedenand the Netherlands), Australia, and Brazil. Phar-maceutical companies accounted for the largestindustry share (18 percent of U.S. 1997 over-seas R&D), which was equivalent to 21 per-cent of their domestically-financed R&D. Muchof this pharmaceutical R&D took place in theUnited Kingdom.

Foreign firms in the United States make sub-stantial R&D investments. From 1987 to 1996,inflation-adjusted R&D growth from majority-owned affiliates of foreign firms averaged 10.9 per-cent per year, and are now roughly equivalent toU.S. companies’ R&D investment abroad. Affili-ates of firms domiciled in Germany, Switzerland,the United Kingdom, France, and Japan collec-tively account for 72 percent of this foreign fund-ing. Foreign-funded R&D in the United Statesin 1996 was concentrated in drugs and medicines(mostly from Swiss, German, and British firms),industrial chemicals (funded predominantly byGerman and Dutch firms), and electrical equip-ment (one-third of which came from Frenchaffiliates).

R&D by character of use

Vannevar Bush is credited for first using theterm “basic research,” which he defined to meanresearch performed without thought of practicalends in his 1945 report to President Roosevelt,Science—The Endless Frontier. Since that time,


policy makers have been concerned about defini-tions that appropriately characterize the variousaspects of scientific inquiry that broadly fall underthe label of R&D and that relate to the linearmodel that Bush proffered.

Definitions are important to the National Sci-ence Foundation because it collects expendituredata on R&D. For those data to accurately reflectindustrial and academic investments in technolog-ical advancement, and for those data to be com-parable over time, there must be a consistent setof reporting definitions.

The classification scheme used by the NationalScience Foundation for reporting purposes wasdeveloped for its first industrial survey in 1953–1954.19 While minor definitional changes weremade in the early years, namely to modify thecategory originally referred to as “basic or funda-mental research” to simply “basic research,” theconcepts of basic research, applied research, anddevelopment have remained much as was implic-itly contained in Bush’s 1945 linear model.

The objective of basic research is to gain morecomprehensive knowledge or understanding of thesubject under study, without specific applicationsin mind. Basic research is defined as researchthat advances scientific knowledge but does nothave specific immediate commercial objectives,although it may be in fields of present or poten-tial commercial interest. Much of the scientificresearch that takes place at universities is basicresearch. Applied research is aimed at gainingthe knowledge or understanding to meet a spe-cific recognized need. Applied research includesinvestigations oriented to discovering new sci-entific knowledge that has specific commercialobjectives with respect to products, processes,or services. Development is the systematic useof the knowledge or understanding gained fromresearch directed toward the production of use-ful materials, devices, systems, or methods, includ-ing the design and development of prototypes andprocesses.20

Approximately 61 percent of national R&D isdevelopment, with 23 percent of R&D being allo-cated to applied research and 16 percent beingallocated to basic research. Different sectors con-tribute disproportionately to the Nation’s funding

and performance of these R&D component cate-gories. Applied research and development activ-ities are primarily funded by industry and per-formed by industry. Basic research, however, isprimarily funded by the federal government andgenerally performed in universities and colleges.The decline in federal support of R&D over thepast decade has primarily come at the expense ofapplied research and development performed inindustry.

R&D activity in large and small firms

Table III shows the level of R&D expendi-tures from all sources for several of the largerR&D-performing firms in the United Statesin 1997. These data come from a variety of pub-lic sources: several patterns can be seen from thedata in the table:

• Microsoft (the tenth-largest R&D-active com-pany) invests about one-fifth of the amountof R&D invested by General Motors (thelargest R&D-active company). Thus, evenamong the R&D giants, R&D expendituresvary dramatically.

Table IIILargest R&D-active U.S. companies

Rank $R&D $R&D/in 1997 Company (millions) $sales (%)

1 General Motors 8�2000 492 Ford Motor Company 6�3270 413 IBM 4�3070 524 Lucent Technologies 3�1006 1185 Hewlett-Packard 3�0780 726 Motorola 2�7480 867 Intel 2�3470 948 Johnson & Johnson 2�1400 959 Pfizer 1�9280 15410 Microsoft 1�9250 169

95 Imation 1949 8996 Dana 1930 2297 Thermo Electron 1916 5498 Eastman Chemical 1910 4199 Cabletron Systems 1818 132100 Whirlpool 1810 21

Source: Science & Engineering Indicators—2000, AppendixTable 2-58.


• Microsoft is, however, more than three timesas R&D intensive as General Motors, meaningthat its invests nearly three times the amountas General Motors relative to its sales.

• In general (with notable exceptions such asCabletron Systems), larger R&D performersalso spend more on R&D relative to their sizethan do the lower-ranked firms in the list ofthe top 100.

• The level of R&D expenditures is not unre-lated to the industry of the R&D performer.For example, first-ranked General Motors andFord Motor Company are in the transporta-tion industry. Second-ranked IBM, LucentTechnologies, Hewlett-Packard, Motorola, andIntel are in information systems.

Company-specific data on R&D expendituresfor small-sized firms are not readily available.However, aggregate NSF data show that $98 bil-lion of the $169 billion that industry spent onR&D in 1998 was performed in firms with 10,000or more employees. Thirty billion dollars (18% ofthe industry total) was performed in firms withfewer than 500 employees. Similarly, 70 percent ofthe funds expended were part of company R&Dbudgets that exceeded $100 million.

Stylized facts aside, there is a more subtleand perhaps more important R&D-related issue.Since the early 1980s, policy makers have beenconcerned that critical American industries werelosing their competitive dominance of world mar-kets. During the 1990s, these same industriesseem to have reemerged as major internationalcompetitors. While some of this resurgence is aresponse to purposive policies, a portion of itcan also be attributable to small firms, many ofwhich were not in existence in the early 1980sto be affected by policy and many of which donot even conduct R&D. Still, during the 1990s,small firms were a driving engine of growth,job creation, and renewed global competitivenessthrough innovation.

There is a rich literature related to the per-formance of R&D in small firms as comparedto large firms. Some of the conclusions from thisresearch are:

• Large firms have a greater propensity to patentthan do small firms.

• Small firms are just as innovative as large firms,in general. But, in some industries, large firmshave the innovative advantage (pharmaceuti-cals, aircraft), while in other industries smallfirms have the innovative advantage (software,biotechnology).

• Small-firm and large-firm innovative activitiesare complementary.

Table IV provides a selected summary of the find-ings from the literature on innovation and firmsize.

The economic importance of small firms,including the innovative differences between smallfirms and large firms, requires an explanationsince the share of overall economic activityattributable to small firms is small and it did notincrease during the 1990s. The explanation rel-evant to the focus of this primer begins with amodel of the knowledge production function.21

Table IVSelected studies of the relationship between innovation and

firm size

Innovationmeasure Findings Authors

R&D R&D spending in Mueller (1967)positively related Grabowski (1968)to firm size Mansfield (1968)

Patents Patenting is Schererpositively or (1965, 1983)proportionally Pakes andrelated to Griliches (1980)firm size Hall et al. (1986)

Schwalback andZimmermann(1991)

New product Parity across firm Acs and Audretschinnovations size, although (1990)

there are Audretsch (1995)differencesaccording toindustry

Adoption of Positive relationship Romeo (1975)advanced between firm size Dunne (1994)manufacturing and the probability Siegel (1999)technologies of adopting an

advancedmanufacturingtechnology


The simplified production function in Equa-tion (1) above can be expanded conceptually andanalytically to include the stock of knowledge as adiscrete input along with K and L. One investmentin knowledge that many firms make is in R&D.However, there are other key factors that generateknowledge for the firm besides R&D, and in factmany small firms do not even conduct R&D yetthey are very innovative. Some such firms rely onknowledge that spills over from external sourcesincluding universities, and small firms are rela-tively more adept at absorbing knowledge fromexternal sources than large firms. Table V pro-vides a brief summary of this spillover literaturewith respect to small firms.

Included in Table V under the source categoryof individual spillovers are new employees. Whyare, for example, small firms able to exploit knowl-edge embodied in new employees to a greaterextent than large firms? New and small firms pro-vide the opportunity for creative individuals to

Table VSelected studies on knowledge spillovers

Spilloversource Findings Authors

Industry Spillovers vary across Jaffe (1989)spillovers industries; greater Saxenien (1990)

spillovers in Acs et al. (1992)knowledge-intensive Trajtenberg andindustries Henderson (1993)

Audretsch andFeldman (1996)

University University spillovers Link andspillovers more important to Rees (1990)

small firms than Audretsch andlarge firms Feldman (1996)

Firm Firm spillovers Acs et al. (1994)spillovers more important to Feldman (1994)

large firms than Eden et al. (1997)small firms

City spillovers Diversity generates Glaeser et. almore spillovers than (1992)specialization; Almeida andlocalized Kogut (1997)competition more Feldman andthan monopoly Audretsch (1999)

Individual Spillovers shaped Audretsch andspillovers by role and Stephan (1996)

mobility of Prevezer (1997)knowledge workers

implement new ideas that otherwise would berejected or would remain unexploited in an orga-nizationally rigid firm. New firms thus serve asagents of change. In a global economy where com-parative advantage is based in large part on inno-vation, small firms are a critical resource. Publicpolicies to enhance innovation in small firms arediscussed below.

R&D activity by geographic location

R&D activities in the United States are highlyconcentrated in a small number of states. In 1997,the 20 highest-ranking states in R&D accountedfor about 86 percent of the U.S. total; the lowest20 states accounted for only 4 percent. Califor-nia, at nearly $42 billion, had the highest level ofR&D expenditures; it alone accounted for approx-imately one-fifth of the $199 billion U.S. total.The six states with the highest levels of R&Dexpenditures—California, Michigan, New York,New Jersey, Massachusetts, and Texas (in decreas-ing order of magnitude)—accounted for nearlytwo-thirds of the national effort. Among thesetop ten states, California’s R&D effort exceeded,by nearly a factor of three, the next-higheststate, Michigan, with $14 billion in R&D expen-ditures. After Michigan, R&D levels declined rel-atively smoothly to approximately $7 billion forMaryland.

States that are national leaders in total R&Dperformance are usually ranked among the lead-ing sites in industrial and academic R&D per-formance. For industrial R&D, nine of the topten states were among the top ten for totalR&D, with Ohio of the top industrial R&D statesreplacing Maryland. For academic R&D, NorthCarolina and Georgia replaced New Jersey andWashington. There was less commonality with thetop ten for total R&D among those states thatperformed the most federal intramural research.Only four states were found in both top-ten lists:Maryland, California, Texas, and New Jersey.

Competition for resources is a fundamentalexplanation for the skewed distribution of R&Dand science resources within the United States.States that lack such resources lag others in inno-vation, scholarship, graduate education, and over-all economic growth.22


The relationship between R&D andproductivity growth

As previously noted, Robert Solow’s seminalarticle in 1957 established that an extremely largepercentage of U.S. economic growth (over 87percent) could not be explained by growth inconventional inputs, i.e., capital and labor. Sincethen, researchers have searched for statisticalcorrelates of this unexplained growth, which iscommonly referred to as technological advance-ment or change. Hence, what these investigatorshave done is to posit that technological change,measured as total factor productivity growth, iscausally related to increased investments in R&D.

Using manufacturing sector, industry, and firm-level data, researchers have examined the strengthof the statistical relationship between R&D andtotal factor productivity growth. These analysesare based on models that correlate estimates ofthe growth of A from Equation (3) with measuresof R&D investment undertaken by firms, indus-tries, or aggregate sectors (depending on the unitof analysis). Mathematics aside, the extent of thecorrelation can be shown to be a measure of therate of return to R&D. This literature is consistentin terms of the following findings:

• the rate of return to privately-funded R&D isrelatively large, ranging on average between 30percent and 50 percent;

• the rate of return to privately-funded basicresearch is significantly greater than toprivately-funded development, the differencesbeing over 100 percent to basic research com-pared to about 15 percent to 20 percent forapplied research plus development; and

• the rate of return to federally-funded researchperformed in industry varies by characterof use; the returns to federally-funded basicresearch performed in industry is over 100 per-cent, while federally-funded development has anegligible return on productivity growth.

See summary Table VI.Related studies have attempted to evaluate the

social benefits, that is the spillover benefits to soci-ety, from industrial R&D. The rates of return toapplied research and development described justabove are for the most part private rates of return.More limited in number than the private rate ofreturn studies, the findings from the social rate

Table VISelected studies of the relationship between R&D and

productivity growth

Findings Authors

87.5% of the increase in Solow (1957)aggregate output between 1909and 1949 can be attributedto technical change

R&D has positive impact on total Terleckyj (1974)factor productivity growth as Scherer (1983)does R&D embodied in purchased Siegel (1997)intermediate and capital goods

Rate of return to privately-financed Mansfield (1980)basic research greater than for Link (1981)applied research or development Griliches (1986)

Lichtenberg andSiegel (1991)

Small direct impact of Link (1981)federally-financed R&D on total Griliches (1986)factor productivity growth

of return studies clearly indicate that the spilloverbenefits to society were somewhere in the 50 per-cent to 100 percent range.

Because of these findings, namely that the pri-vate and social rate of return to R&D is rela-tively high, policy makers have remained focusedon R&D investments in the private sector as a tar-get variable for stimulating economic growth. Theargument underlying such a focus is that, throughincentives, firms will continue to invest in addi-tional R&D projects and thus continue to stim-ulate economic growth and enhance standards ofliving through additional spillover effects.

Most of the academic studies associated withthis line of research were funded by the NationalScience Foundation during the late 1970s andearly 1980s, motivated in large part by a slowdownin industrial productivity growth that began in theearly 1970s23 and increased in the late 1970s andearly 1980s (see Figure 3) and by the fact that U.S.industries were losing their competitive advantagein global markets.24 It is not surprising then that inthe early 1980s, given the findings that the privateand social rates of return to R&D were very high,that there were several important policy initiativesdesigned specifically to stimulate industrial R&D.


6. Government’s role in innovation

The government should have an important roleto play in fostering innovation, especially private-sector innovation. The following reasoning hasbeen used to justify government intervention inthe innovation process:

• Innovation results in technological advance.• Technological advance is the prime driver of

economic growth.• Government has a responsibility to encourage

economic growth.

However, the economic underpinnings of gov-ernment’s role in innovation are more complexthan might first appear. From an economic per-spective, the justification for the role of govern-ment in innovation rests on a comparison of theefficiency of market resources with and withoutgovernment intervention.

Economic rationale for government involvement

Even today, many policy makers and academicspoint to Science—The Endless Frontier to date theorigins of U.S. science and technology policy.25

Vannevar Bush did not articulate a science andtechnology policy, and he did not articulate aneconomic rationale for government’s role. Rather,Bush like his predecessors and contemporariessimply assumed that the government had a roleto play in the innovation process, and then he setout to describe that role (as opposed to a rationalefor that role).

The first U.S. policy statement on science andtechnology was issued in 1990 by President Bush,U.S. Technology Policy. As with any initial policyeffort, this was an important general document.However, precedent aside, it too failed to articu-late a rationale for government’s intervention intothe private sector’s innovation process. Rather,like Science—The Endless Frontier and subsequentreports, it implicitly assumed that government hadsuch a role, and it then set forth a rather generalgoal (1990, p. 2):

The goal of U.S. technology policy is to make the best useof technology in achieving the national goals of improvedquality of life for all Americans, continued economicgrowth, and national security.

President Clinton took a major step forward inhis 1994 Economic Report of the President by firstarticulating principles about why the governmenthas a role in innovation and in the overall techno-logical process (p. 191):

Technological progress fuels economic growth � � � TheAdministration’s technology initiatives aim to promotethe domestic development and diffusion of growth- andproductivity-enhancing technologies. They seek to correctmarket failures that would otherwise generate too littleinvestment in R&D � � � The goal of technology policy isnot to substitute the government’s judgment for that of pri-vate industry in deciding which potential “winners” to back.Rather the point is to correct [for] market failure � � � .

Although the 1994 Economic Report of thePresident did not expand on how to correct formarket failure much less discuss appropriate pol-icy mechanisms for doing so, it did for the firsttime posit an economic rationale for governmentinvolvement in the innovation process. Even morerecently, the 1998 so-called Ehlers report, Unlock-ing Our Future, fails to articulate a clear rationalefor government’s involvement although it vastlydeparts in a positive way from the linear modelof technology development proffered by Bush.

Barriers to technology and market failure

Market failure refers to conditions under whichthe market, including those performing R&Dand those adopting the R&D outputs of others,underinvests from society’s perspective in any par-ticular technology. Such underinvestment occursbecause of conditions that prevent firms from fullyrealizing or appropriating the benefits expectedfrom their investments. Stated alternatively, firmsunderinvest in R&D when they determine, basedon their expectations of post-innovation activity,that their private return is less than their privatehurdle rate (minimum acceptable rate of returnon their R&D investment). This is of public con-cern when the R&D investment not undertaken issocially desirable.

There are a number of factors that explain whya firm might perceive its private return to be lessthan its hurdle rate. These factors are what we callbarriers to technology and they relate to technicaland market risk, where risk is defined to mea-sure the possibility that an actual outcome willdeviate from an expected outcome. Also, a firm


may believe that it cannot appropriate a sufficientreturn on its R&D investment, even if it can over-come technical uncertainty. This may be due toa perceived inability to maintain proprietary con-trol of the technology, thus enabling rivals to imi-tate their invention and reducing any resultingprofitability. Individually or in combination, thefollowing factors contribute to why a firm mayperceive a private rate of return as being less thanits hurdle rate26:

• Because of high technical risk, the outcome ofthe R&D may not solve the technical problemadequately to meet perceived needs.

• Even if the R&D is technically successful, themarket may not accept the technology becauseof competing alternatives or interoperabilityconcerns.

• Even absent technical and market risk, it maybe difficult to assign intellectual property rightsto the technology, and it might be quickly imi-tated so that the innovator may not receiveadequate return on the R&D investment.

These factors create barriers to investing in tech-nology, which thus lead to market failure.

From an economic perspective, the role of gov-ernment is to correct for these market failures inthose instances where society will benefit from thetechnology. This latter situation occurs when therate of return to society is greater than the socialhurdle rate (minimum accepted rate of returnfor society from investments of resources withalternative social uses), as illustrated in Figure 6.27

The social rate of return is measured on thevertical axis along with society’s hurdle rate oninvestments in R&D. The private rate of returnis measured on the horizontal axis along with theprivate hurdle rate on investments in R&D. A 45-degree line (long dashed line) is imposed on thefigure. This is the point at which the social rate ofreturn from an R&D investment equals the pri-vate rate of return from that same investment. Thearea above the 45-degree line and to the left of theprivate hurdle rate is the area of policy interest.

Three R&D projects are labeled in the figure.As drawn, the private rate of return exceeds theprivate hurdle rate for project C, and the socialrate of return exceeds the social hurdle rate. Thegap, measured vertically, between the social andprivate returns reflects the spillover benefits to

Social Rateof Return

Private Hurdle Rate

A B C

S

Private Rate of Return

ocial Hurdle Rate

450

Figure 6. Gap between social and private rates of return toR&D projects.

society from the private R&D investment. How-ever, the inability of the private sector to appropri-ate all benefits from its investment is not so greatas to prevent the project from being adequatelyfunded by the private firm.

In general, then, any R&D project that isexpected to lead to a technology with a privaterate of return to the right of the private hurdlerate and on or above the 45-degree line is nota candidate for public support, and hence gov-ernment does not have an intervening role froman economic perspective. Even in the presence ofspillover benefits, project C will be funded by theprivate firm.

For projects A and B, the gap between thesocial and private returns is larger than in the caseof project C; neither project A nor B will be ade-quately funded by the private firm as evidenced bythe private rate of return being less than the pri-vate hurdle rate. To address this market failure,the government has several policy mechanisms.

Before examining specific policy mechanisms,a critical question is: Do private-sector firms, ordoes industry, underinvest in R&D? Alternativelystated: Are there many projects like A and B thatthe private sector considers but rejects for somereason?

Private firms may not pursue promising techni-cal opportunities for the following reasons:

• R&D scientific and technical frontiers are riskyand the chances of failure are high.

• An individual firm may not have the capa-bilities required to develop the technology.


Complex new technologies may require col-laboration and information sharing; however,the cost of establishing research and develop-ment partnership and making then work pro-ductively may provide disincentives to under-taking the project.

• Private incentives may not be sufficient toinduce a firm to undertake the project in theface of difficulties in appropriating the result-ing benefits (i.e., the resulting knowledge mayfollow to others who may benefit from theR&D without sharing the cost).

Government has at its disposal at least four pol-icy mechanisms to reduce risk and market fail-ure and thus overcome an underinvestment inR&D, where underinvestment refers to the situ-ation where the private sector invests less in R&Dthan society would like it to invest (such as forproject A and project B). These policy mecha-nisms include:

• Patent laws• Tax incentives• Improved environment for collaborative re-

search• Subsidies to fund the research

Each mechanism is discussed in the sections thatfollow.

The U.S. patent system is more of an institu-tion than a policy mechanism. Thus, patent laws,in a sense, characterize the overall innovative envi-ronment in which firms operate. In contrast, taxincentives, efforts to stimulate collaborative R&D,and direct and indirect government subsidies arein a sense policy levers.

7. The patent system

The history of the U.S. patent system dates to theauthority given to Congress in the Constitution ofthe United States.28 Article I, section 8 states:

Congress shall have power � � � to promote the progressof science and useful arts, by securing for limited times toauthors and inventors the exclusive right to their respectivewritings and discoveries.

Based on this authority, Congress initiated a num-ber of patent laws.29 The version of law that is nowin effect was enacted on July 19, 1952 (to be effec-tive January 1, 1953). It is Title 35 in the UnitedStates Code.

The Patent and Trademark Office issuespatents for inventions. The patent term is 20 years,and it grants exclusive property rights to the inven-tor over that period of time. Patents are effectiveonly within the United States and its territoriesand possessions.

U.S. law is clear about what can be patented.Any person who:

invents or discovers any new or useful process, machine,manufacture, or composition of matter, or any new anduseful improvement thereof, may obtain a patent.

It is important to note the word “useful,” recallingtoo that Franklin created the American Philosoph-ical Society of Philadelphia in 1742 to promote“useful knowledge.” One cannot patent an idea.30

While the U.S. Code applies to patents in theUnited States, and in the territories and posses-sions of the United States, treaties have been pro-mulgated to extend protection beyond nationalboundaries. The Paris Convention for the Pro-tection of Intellectual Property of 1883 providedthat each of the 140 signatory nations recognizesthe patent rights of other countries. Subsequenttreaties have extended such coverage and madefilings in other countries more efficient.

Figure 7 illustrates the economics of patentingfrom the perspective of the firm. The marginalprivate rate of return to R&D is measured onthe vertical axis and the level of R&D spendingis measured on the horizontal axis. The marginalprivate return schedules are downward slopingreflecting diminishing returns to R&D in any giventime period, and for simplicity we assume themarginal private return schedule to be linear.

Marginal Private Rate of Return

Marginal Private Cost

Marginal Private Return with a patent

Marginal Private Return without a patent

R&D Expenditures RD0 RD1

Figure 7. Economics of patenting: i

the economics of science and technology · cisely these issues that may be most critical in...

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