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The economics of research and development : how research and development capital affects production and markets and is affected by tax incentives

  • Shah, Anwar
  • DEC

Certain themes and findings emerge from the authors analysis of key relationships between research and development (R&D) and other factors. Among them: (1) R&D capital and the structure of production: (a) R&D capital facilitates the mapping of technological possibilities into economic opportunities. (b) R&D takes time to accumulate and uses up scarce resources. The adjustment process from project initiation to product and process development typically takes three to five years. (c) The marginal adjustment costs for R&D are higher than for plant and equipment. (d) R&D capital is a complement to physical capital but is a substitute for labor in the long run. (e) Output changes exert a much stronger influence on R&D capital than vice versa. (2) R&D capital and market structure: the value of cost-reducing R&D is determined by its profitability. Since private returns from R&D understate true social returns from such investments, R&D will be underprovided. And since R&D investments often represent large fixed costs, market structures in R&D intensive industries is going to be concentrated. This situation is, however, not unique to R&D. What is unique about R&D is the nature of spillovers. These spillovers reduce industry costs, but since they result in inappropriability of returns from the R&D performer, incentives to do R&D are reduced. Restoring appropriability does not help matters either because it results in industrial concentration, incorrect pricing of R&D, and higher social costs. Perfect appropriability may also result inexcessive R&D because too many firms may be fishing for the same information. The information asymmetry between an R&D performer and a financier distinguished R&D investment from traditional risky investment. It is in the interest of the R&D performer to keep vital project information secret. But in the absence of detailed information, project financing may not be forthcoming. Asymmetric information also limits the R&D firm's ability to profit from its output. Success breeds success. Since learning involves costs, successful firms possess an advantage over their rivals in enjoying greater possibilities for success. So, monopoly persists in the R&D capital market. Past successes from R&D investments lead to greater current R&D efforts by successful firms. These firms tend thereby to produce further innovations and thus widen the gap between themselves and their rivals. Much R&D capital is concentrated in large firms, but it is more likely that they have become large because of their R&D successes than that they do more and more fruitful R&D because they are large. (3) Public policy and R&D investment: (a) Most industrial nations see the need to intervene through the tax code to encourage R&D activities. Empirical evidence on the effectiveness of such initiatives is limited. (b) An analysis of parameter estimates for a cost function of the Canadian industries suggests that R&D tax credits had a significant positive impact on R&D investment in Canada. For every dollar of revenue foregone for the national treasury, $1.80 worth of additional R&D investment was undertaken. This suggests that properly designed tax incentives can further public policy objectives cost-effectively.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1325.

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Date of creation: 30 Jun 1994
Date of revision:
Handle: RePEc:wbk:wbrwps:1325
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