Industrial Research versus Development Investment: The Implications of Financial Constraints

Industrial research and development (R&D) activities constitute an important driver of economic competitiveness. The impact of R&D on productivity at the firm level stems from the implementation of newly generated knowledge and technological discoveries into new products, processes or services. Particularly the 'R' component of R&D has been found to drive productivity at the firm level. That is firms that invest a larger fraction of their total R&D on research (relative to development) are more productive both in terms of the production of new knowledge, e.g. patens as well as overall factor productivity. However, economic theory suggests that two types of market failure affect private investments in research. First, private rates of return from research activities are smaller than social rates of return because of the incompleteness of appropriability of the knowledge that is being created by investment. Second, especially for (basic) research firms may face difficulties in attracting external investors or get bank loans for financing these activities. Complexity, specificity and outcome uncertainty of such investment projects may make it particularly difficult for outsiders to judge the expected return of 'R' projects. Hence, for firms with limited internal liquidity R&D investments may therefore be constrained. If information asymmetries are larger for 'R' than for 'D' financing constraints may be more binding for 'R' projects. Underinvestment in 'R', however, may result in a noticeable slowdown in productivity growth and consequently have particularly detrimental effects on technological progress and economic development. Previous studies on financing constraints for R&D do not explicitly distinguish between the different components of R&D. This article explicitly takes the heterogeneity of the two components into account. We argue that financing development 'D' externally should be less critical than it is for industrial research 'R'. First, our results show that firms’ investment in 'R' are more sensitive to liquidity than investments in 'D' indicating that firms have to rely even more on internal funds for financing the former type of activities. This may be due to the fact that the latter occurs later in the R&D process and is closer to yielding returns. That is, firms cut 'R', before they reduce 'D' if they have to allocate scarce internal funds. This has implications for R&D policy. If financial constraints for R&D are driven by the 'R' component, industrial research projects may deserve special support. Second, we show that public subsidies directed at 'R' indeed alleviate financing constraints.

Czarnitzki, Dirk, Hanna Hottenrott and Susanne Thorwarth (2009), Industrial Research versus Development Investment: The Implications of Financial Constraints, ZEW Discussion Paper No. 09-049, Mannheim, published in: Cambridge Journal of Economics.