The normative literature on R&D has focused exclusively on the question of the appropriate magnitude of R&D subsidies. Other government interventions, including direct involvement by public organisations on conducting R&D, have been entirely ignored. In particular, there is no theoretical argument for the public sector direct involvement in conducting innovation activities. This project explores the role of public organisations in conducting R&D from two distinct perspectives. On the empirical side, the project analyses whether it is possible to establish the causal effect of Fraunhofer on Germany’s innovation and technology adoption performance. On the theoretical side, it will be investigated if public organisations directly engaged in the innovation process improve its efficiency beyond what standard R&D subsidies could achieve. Our proposal are organised around these two questions:First, we study what effects a public German applied R&D organisation, the Fraunhofer Institutes, has on the patenting activity of private companies it collaborates with. We will develop a new data set comprising MIP, Patent, and Public R&D Funding data. We will analyse probit or multinomial probit models to estimate the impact of firm characteristics (firm size, age, industry, exporting activity) and characteristics of the knowledge base (e.g. patent stock, human capital), innovative investments (R&D intensity, no. of R&D employees), government R&D subsidies, and the proximity of firms and Fraunhofer Institutes in the technology space on probability of Fraunhofer-industry links.Second, we study the existence of theoretical foundations for a public organisation such as Fraunhofer to be directly involved in conducting applied R&D. Public R&D organisations seem to be contributing to the innovation process with inputs and services the private sector does not provide. To us, this is an indication that existing R&D models ignore some mechanisms that in reality are important in determining the output and efficiency of innovation and technology upgrading processes. We will enrich standard R&D models along various dimensions. We will show that policy instruments beyond R&D subsidies and R&D project grants will have a positive impact on welfare. There are three arguments that we consider as part of an optimal R&D policy. These are (i) the assimilation of knowledge created in R&D activities; (ii) the presence of multi-disciplinary projects; and (iii) the diffusion of innovation in the economy.