ECONOMIC
ANALYSIS
OF RESEARCH SPILLOVERS
IMPLICATIONS FOR THE
ADVANCED TECHNOLOGY PROGRAM
by
Adam B. Jaffe
Brandeis University
and
National Bureau of Economic Research
Prepared for the
Advanced Technology Program December 1996
TABLE OF CONTENTS
EXECUTIVE
SUMMARY
I.
INTRODUCTION AND OVERVIEW
II. ECONOMIC
ANALYSIS OF R&D SPILLOVERS
III. REVIEW OF ECONOMIC
LITERATURE RELATING TO SPILLOVERS
IV. FRAMEWORK FOR EXPLICIT
EVALUATION OF SPILLOVER POTENTIAL OF ATP PROPOSALS
V. INCORPORATING
SPILLOVER CONSIDERATIONS INTO FUTURE RESEARCH
VI. CONCLUSION
BIBLIOGRAPHY
EXECUTIVE SUMMARY
Economists and other
social scientists have demonstrated that the R&D activities of private
firms generate widespread benefits enjoyed by consumers and society at
large. As a result, the overall economic value to society often exceeds
the economic benefits enjoyed by innovating firms as a result of their
research efforts. This excess of the social rate of return over
the private rate of return enjoyed by innovating firms is described
by economists as a positive externality or spillover. These spillovers
imply that private firms will invest less than is socially desirable in
research, with the result that some desirable research projects will not
be undertaken, and others will be undertaken more slowly, later, or on
a smaller scale than would be socially desirable.
These spillovers flow
through a number of distinct channels. First, spillovers occur because
the workings of the market or markets for an innovative product or process
create benefits for consumers and non-innovating firms ("market spillovers").
Second, spillovers occur because knowledge created by one firm
is typically not contained within that firm, and thereby creates value
for other firms and other firms' customers ("knowledge spillovers"). Finally,
because the profitability of a set of interrelated and interdependent
technologies may depend on achieving a critical mass of success, each
firm pursuing one or more of these related technologies creates economic
benefits for other firms and their customers ("network spillovers").
The ATP would like
to invest in projects that have a high social rate of return, but that
would be underfunded, delayed or otherwise inadequately pursued in the
absence of ATP support. This objective can be furthered by pursuing projects
for which the gap between the social and private rates of return ("the
spillover gap") is large. Existing ATP analyses--including examination
of broad-based economic benefits, consideration of whether a technology
is "enabling," and consideration of the need for ATP funding-- implicitly
address the likely extent of the spillover gap for proposed projects.
Better understanding of the pathways of spillovers can improve this process.
Researchers have identified
characteristics of the market and technological environment that make
spillovers more or less likely. Explicit consideration of these characteristics
can be used to improve the likelihood that the ATP will fund high-social-return
projects that would otherwise have been underfunded. These considerations
include:
- competitiveness
of the market or markets in which the innovation will be commercialized
- the role of "lead
time" and "learning curves" in conveying advantages that are likely
to permit innovators to reap a large fraction of the benefit of their
innovations
- the role of marketing,
sales and service, regulatory expertise and other "cospecialized assets"
in determining whether the returns to innovation can be captured by
the innovator
- benefits of coordinated
research that may arise if the returns to specific research investments
are dependent on success by a "critical mass" of related projects
- the likelihood
of negative spillovers through obsolescence
of existing technology
- attributes of "enabling"
technologies
- need for licensing
for successful commercialization
- role of legal mechanisms
for intellectual property protection in protecting returns
Further research could
help clarify and expand the extent to which these and other factors can
be used to predict the spillover potential of proposed projects. As experience
with ATP projects accumulates, research can document the extent of spillovers
created, the extent to which the factors listed above do predict spillovers,
and the existence of other factors that are associated with the realization
of large spillover benefits.
I. INTRODUCTION
AND OVERVIEW
Economists use the
term "spillover" to capture the idea that some of the economic benefits
of Research and Development (R&D) activities accrue to economic agents
other than the party that undertakes the research. Purchasers of better
or cheaper products, competing firms that imitate a successful innovation,
and firms whose own research benefits from observation of the successes
and failures of others' research efforts all garner such spillover benefits.
As these examples suggest, these spillovers are created by a combination
of the new knowledge resulting from an R&D effort, and the commercialization
of the new technology in terms of a product or process that is successfully
implemented in the marketplace. Thus a complete understanding of the R&D
spillover phenomena requires an unusual combination of scientific/technical
and business/economic analysis.
Standard economic
analysis postulates that economic agents try to maximize their self interest.
In the context of R&D, this implies that firms make decisions about
the level and focus of their R&D efforts based on maximization of
their long-run profit. Firms deciding whether or not to pursue a particular
line of research, or deciding on the margin what level of resources to
devote to a research project, try to balance, in some rough way, the cost
of the R&D against the future profits that the effort might yield,
taking into account the tremendous uncertainty about both the overall
costs and benefits. Because of research spillovers, there are benefits
that are created for the economy and for society when a firm undertakes
a research project (or increases its level of commitment to an ongoing
project) that are ignored in this cost/benefit calculation.
(1) The social rate of return to R&D
will generally exceed the private rate of return.
(2) Since firms make their decisions based
only on the private rate of return, they will fail to undertake some projects
that are socially desirable, and they will generally pursue the projects
that they do undertake at a level of resource commitment that is lower
than is desirable from the point of view of society as a whole. In economists'
jargon, there is a "market failure" with respect to R&D that results
in market forces allocating fewer of society's overall resources to R&D
than is desirable.
R&D spillovers
are thus an example of a positive externality. Other examples of activities
that generate positive externalities (and hence are underprovided by a
laissez-faire market system) include prompt garbage removal, inoculations
and employee training. The concept of positive externalities is very closely
related to the concept of "public goods." In the limit, the benefits of
an activity may be so diffuse that no individual or firm would undertake
the activity on their own, such as national defense. R&D (and the
other examples in this paragraph) fall in an intermediate range in which
the activity generates sufficient benefit to the party undertaking it
that market forces generate some, but not enough, of the activity.
The market failure
created by R&D spillovers is one of the primary justifications for
government policies designed to encourage R&D. This report will describe
what is known by economists about the phenomenon of R&D spillovers,
and assess the relevance of this knowledge for the ATP. A thorough understanding
of the spillover process is important to the ATP for at least three reasons.
First, since a large fraction of aggregate R&D expenditures are funded
by other government programs, and the U.S. tax code creates significant
incentives to privately-funded R&D, the policy justification for the
ATP rests on a demonstration that the program incrementally increases
social returns, relative to what would occur in its absence. In other
words, it is insufficient simply to cite the existence of spillovers.
The ATP must be able to show that the government policy portfolio including
the ATP is more effective at correcting the R&D market failure than
the portfolio without the ATP would be.
Second, better understanding
of the spillover process will facilitate selection of projects for funding
by the ATP so as to maximize the social rate of return to the ATP expenditures.
While there is inherently much uncertainty regarding the spillover potential
of particular projects (just as there is much uncertainty about their
technical potential), it is possible to identify generic features that
will tend, on average, to be associated with a greater likelihood of spillovers.
Finally, to the extent
that the policy justification for the ATP lies in creating spillovers,
then any attempt to evaluate the ATP's success must try to measure those
spillovers. Hence a better understanding of the process will foster the
development of data collection and research efforts that are appropriate
to quantification of the spillovers generated by the ATP investments.
The spillover phenomenon
is not the only factor that may cause socially desirable research efforts
to be underfunded. In particular, capital market imperfections have the
effect that risk and financial factors may also impede socially desirable
research and development efforts. This report does not provide an explicit
analysis of these other factors, but does consider their likely interaction
with the spillover process, and the consequences of this interaction for
the ATP.
The next section
of this report will discuss the analytical underpinnings of the spillover
concept in more detail, and relate this analytical framework to analyses
already undertaken by the ATP. Section III will discuss the findings of
economic research regarding the magnitude of spillovers, and the circumstances
that make them more or less likely. Section IV then suggests ways in which
the current ATP analysis of spillovers could be expanded, and considers
the difficult issues raised by the interaction of spillovers, risk, and
private decisions regarding R&D expenditures. Section V discusses
the issue of designing research and data collection to measure spillover
impacts and improve the ability of the ATP to assess the likely spillover
potential of project proposals. Section VI provides concluding comments.
II. ECONOMIC
ANALYSIS OF R&D SPILLOVERS
A. Sources
of Spillovers
Spillovers have been
of interest to economists since at least the nineteenth century. At that
time, organized scientific research was uncommon in industrial firms.
Technological knowledge was built more by informal "tinkering" and learning
by doing. Alfred Marshall, one of the founders of modern microeconomics,
made such informal learning a centerpiece of his analysis of the evolution
of the modern, large industrial firm. He wrote that:
Many of those economies
in the use of specialized skill and machinery which are commonly regarded
as within the reach of very large establishments, do not depend on the
size of individual factories. Some depend on the aggregate volume of production
of the kind in the neighborhood; while others again, especially those
connected with the growth of knowledge and the progress of the industrial
arts, depend chiefly on the aggregate volume of production in the whole
civilized world. (Marshall, 1920)
He argued that R&D
spillovers were on the rise, remarking, "the secrecy of business is on
the whole diminishing, and the most important improvements in method seldom
remain secret for long after they have passed from the experimental stage."
Analytically, it is
useful to distinguish several different mechanisms by which R&D generates
spillovers. For convenience, I refer to these as "knowledge spillovers,"
"market spillovers," and "network spillovers." In order to think through
the implications of spillovers for the ATP, it is useful to consider each
of these separately, and then to note that they also interact in a way
that tends to increase their combined effect.
1.
Knowledge spillovers
The quote from Marshall
refers to the phenomenon of knowledge spillovers. Knowledge created by
one agent can be used by another without compensation, or with compensation
less than the value of the knowledge. Knowledge spillovers are particularly
likely to result from basic research, but they are also produced by applied
research and technology development. This can occur in obvious ways, such
as "reverse engineering" of products, and also in less obvious ways, such
as when one firm's abandonment of a particular research line signals to
others that the line is unproductive and hence saves them the expense
of learning this themselves. The spillover beneficiary may use the new
knowledge to copy or imitate the commercial products or processes of the
innovator, or may use the knowledge as an input to a research process
leading to other new technologies.
In some circumstances
the creation of knowledge spillovers is intentional on the part of the
innovator; the publication of scientific papers is, at least in part,
intended to spread new knowledge so that it can be used by the widest
possible audience. In the case of patented inventions, society requires
disclosure of new knowledge as a quid pro quo for the granting of monopoly
rights in the commercial use of an invention. The effect of this disclosure
is, in principle, to make the new knowledge available to others for the
purpose of facilitating new and different applications, while at the same
time protecting the inventor against copying.
Knowledge spillovers
also occur when researchers leave a firm and take a job at another firm
(or start their own). While trade secret law gives firms some ability
to protect knowledge they have created, it is extremely difficult to effectively
protect tacit knowledge about successful and unsuccessful approaches,
mechanisms etc. Further, important innovative successes are likely to
increase the incentives for researchers to capitalize on their tacit knowledge
by moving to another firm or starting their own.
More generally, commercial
development and use of new knowledge will tend to cause it to spread,
despite any desire of the inventor to prevent such spread. Economic exploitation
of new knowledge requires the sale of new commercial products embodying
that knowledge or the incorporation of that knowledge into new commercial
production processes. Such commercialization tends, in general to reveal
at least some aspects of the new knowledge to other economic agents. Hence
the very process of economically exploiting the knowledge that research
creates tends to pass that knowledge to others. Because the spread of
knowledge is greatly affected by the commercial use of new technology,
even the analysis of "knowledge" spillovers must be informed by an understanding
of the market mechanisms that govern the spread of new technology.
2.
Market spillovers
Market spillovers
result when the operation of the market for a new product or process causes
some of the benefits thereby created to flow to market participants other
than the innovating firm. It is this "leakage" of benefits through the
operation of market forces, rather than the flow of knowledge itself,
that distinguishes market spillovers from knowledge spillovers. Any time
a firm creates a new product, or reduces the cost of producing an existing
product, the natural operation of market forces will tend to cause some
of the benefits thereby created to be passed on to buyers.
Consider first the
case of new or improved products. It is likely that a firm that sells
a better mousetrap will charge a price that is higher than that being
charged for ordinary mousetraps. But innovative products, even those that
are patented or otherwise protected from direct competition, will generally
be sold at prices that do not fully capture
all of the superiority of the new product relative to what was available
before. As a result, consumers will be made better off by the introduction
of the new product. This increase in consumer welfare is a social benefit
from a new product that is not captured by the innovator. (3)
Similarly, if a company does R&D to lower its production cost, it
will typically lower its selling price as a result. Again, the innovator's
customers are better off, and a benefit is created that is not captured
by the innovator. Of course, innovation often results in both higher quality/performance
and lower prices; thereby benefiting customers even more.
3.
Network spillovers
Network spillovers
result when the commercial or economic value of a new technology is strongly
dependent on the development of a set of related technologies. An example
of network spillovers exists among all of the different developers of
application software for use with a new operating system platform. If
one firm develops a particular application, people will buy it only if
many other firms develop other sufficient applications so that the platform
itself is attractive and widely used (4)
If the commercial
payoff to each of a set of related research
projects is dependent on all or a significant fraction of the
projects being completed successfully, then private firms might hesitate
to undertake any one of the projects, for fear that the others will not
be undertaken. Conversely, if any one firm decides to undertake such a
project, it creates a positive externality for all the other firms, by
increasing the probability that the "critical mass" will be achieved.
Note that this positive externality or spillover exists even if there
is no knowledge spillover among the firms (although it is likely that
knowledge spillovers would also be occurring).
The existence of network
externalities creates a "coordination problem" that is another possible
market failure associated with research. Where network externalities are
important, it is possible that firms' inability to coordinate their efforts
will lead to a misdirection of research effort, away from the activities
associated with network externalities, even if firms are in the aggregate
undertaking a socially efficient level of research
effort.
It is important to
emphasize that the coordination problem only arises if there are reasons
why a single firm cannot develop all of the necessary related components
(or contract with others for their development) and thereby internalize
the network externality. Thus while you cannot run a computer without
an operating system, the need for the operating system software does not
create an important coordination problem, as the hardware manufacturer
can either write the operating system itself or contract for its creation.
What distinguishes the operating system (which does not create a significant
network externality) from the need for applications programs (which might)
is the likelihood that many different applications
will ultimately be necessary, and that it is unlikely that one firm would
have all the capabilities to create all of these different applications,
or even to know what the set of necessary applications will ultimately
look like. To put it differently, synergistic market interactions among
a small number of technologies is unlikely to create a coordination problem,
but when the number of technologies that must be developed is large and
the necessary capabilities are diverse, the coordination problem may become
severe.
There are a number
of different mechanisms by which the coordination problem created by network
externalities can be handled. Research joint ventures, in which a number
of companies combine forces, can be used to pursue the interrelated approaches
whose commercial success is interdependent. By fostering the creation
of such joint ventures, the ATP assists this process. In addition, the
formation of focused programs targeted at a set of interrelated technologies
can be used to try to ensure that a critical mass will be reached. Focused
programs are discussed in section IV.C.
B. Private
and Social Returns to R&D
1.
Pure market spillovers
As noted above, the
effect of spillovers is to create a gap between the private rate of return
to R&D (the return or profit earned by the firm undertaking the research)
and the social rate of return, which includes the private return but also
includes benefits to the firms' customers and to other firms. The nature
of this spillover gap in the context of market and knowledge spillovers
is illustrated in Figures 1, 2, and 3.
Figure 1 illustrates
a "pure" market spillover. If "firm 1" invests in R&D, this generates
new knowledge, leading eventually to improved products or lower production
costs for firm 1.(5)
Figure 1
The operation of competition
in the markets where firm 1's products are sold will divide the economic
benefit of these improvements between firm 1's profits and benefits captured
by customers in the form of lower prices or higher quality. The total social
return to the innovation is comprised of the customer benefit plus the profits
accruing to firm 1; the private return is only firm 1's profits, and hence
there is a "spillover gap" consisting of the customer benefit.(6)
The more competitive are the markets in which firm 1's products are sold,
the greater will be the share of the economic benefit that will be driven
out of firm 1's profit and into the benefits captured by firm 1's customers.
Economists would say
there is an "appropriability" problem, because firm 1 is not able to appropriate
to itself all of the benefits created by its investment in research. Of
course, firms will attempt to solve the appropriability problem, using
various mechanisms to try to capture the fruits of research. Economists
studying the innovation process have identified a number of such appropriability
mechanisms, and have identified market conditions that tend to make them
more or less successful. This research is discussed in Section III.B.
It is obvious from
Figure 1 that the market spillovers will not be realized unless the innovation
is commercialized successfully. Market spillovers accrue to the customers
that use the innovative product; they will not come to pass if a technically
successful effort does not lead to successful commercialization.
An interesting case
-- and one that illustrates the dividing line between knowledge spillovers
and market spillovers -- occurs when a firm invests its resources in developing
an improved input to its own production process, such as a new material
or a new machine tool. Often, the firm will then work with its supplier
firms to produce this new input. The innovator will get the benefit of
the innovation in its own production (and its customers
will enjoy market spillovers), but the supplier may, in turn, sell the
improved input to other firms, creating profits for itself and benefits
to those purchasing firms (and their customers).
One could think of
this as a knowledge spillover, in the sense that the knowledge created
by the innovator has leaked to its supplier. But the transfer of knowledge
to the supplier is not an accident, it is a necessary step in implementing
the innovation. In theory, one could imagine the innovator writing a contract
with the supplier that ensures that all of the benefits of future sales
are captured by the innovating customer. In practice, such a contract
is impossible to write; the inability to write such a contract is a market
imperfection that creates the market spillover. In other words, knowledge
spillovers can be thought of as benefit leakages that occur in the absence
of a market interaction between the innovator and the spillover beneficiary,
whereas market spillovers result from a market interaction between them.
Note that market spillovers
occur whether the purchaser of the new product is a household or another
firm. In the case of improved intermediate products, then the market spillover
benefits will be passed to the purchasing firms, which will in turn tend
to pass at least some of this benefit to their customers. For example,
if a supplier to the auto industry develops a better material, that material
will be sold to auto companies at a price that does not fully reflect
its improved properties. In turn, the auto companies will sell the better
autos to consumers at a price that is either lower than before (if the
new material significantly reduced production costs) or else results in
a price/quality combination that is superior from the consumers' point
of view. Such a chain of spillovers can be quite long; a new catalyst
could permit economic production of a new polymer that results in a better
fiber that is used in better fabric that is eventually incorporated in
a better garment.
An important case
of market spillovers associated with intermediate goods is where the innovation
is an input to the research process, such as a new material or instrument.
The purchaser is another researcher, who will typically use the new device
in ways that create further spillovers. This case of "infratechnologies"
is discussed further below.
2.
Pure knowledge spillover
Figure 2 illustrates
the effect of adding a "pure" knowledge spillover. By "pure," I mean a
knowledge spillover that flows to firms that do not compete in firm 1's
markets. Their increase in knowledge as a result of firm 1's research
allows them to improve their products or lower their costs, increasing
their profits and customer benefits in their markets.(7)
Both these profits and the consumer benefits are part of the social return,
but are not captured by firm 1, and so the spillover gap is increased.
Figure 2
Note that even in
the case of knowledge spillovers, the social return is created by the
commercial use of a new process or product,
and the profits and consumer benefits thereby created. The difference
between market spillovers and knowledge spillovers is that in the former
case the commercial benefits are created in the market for the new product
or process that is the direct "output" of the research effort, while in
the case of knowledge spillovers the commercial benefits are created indirectly
through the creation of new or improved products or processes in other
markets. Though as a society we value "knowledge for knowledge's sake,"
I am not including such non-economic value within the concept of knowledge
spillovers used here.
Figure 2 indicates
that the knowledge spillovers flow to some extent from firm 1's creation
of new knowledge, and to some extent from firm 1's commercialization efforts.
This reflects the idea that other firms may learn to some extent from
papers, patents, departing employees, and other disembodied outputs of
firm 1's research, but they are likely to learn more when firm 1's research
results are actually embodied in new commercial products and processes.
The relative importance and the speed of these two pathways will vary,
depending on the nature of the research. In general, knowledge spillovers
from more basic research would be expected to flow mostly from the research
results themselves, and to take a fairly long time to have the commercial
impact indicated in the lower part of Figure 2.(8)
On the other hand, knowledge spillovers from applied research and development
are more likely to flow from the products or processes embodying the research
results, and thereby have a quicker economic impact.
Thus, for the kinds
of applied research and development projects that are the focus of the
ATP, the realization of spillover benefits, and social returns more broadly,
is strongly dependent on successful commercialization of the new technology.
This is true both for market spillovers (which depend entirely on commercialization)
and knowledge spillovers (which are likely to be largely dependent on
and speeded by commercialization). New technology that remains "on the
shelf" does not benefit customers, and hence does not create market spillovers,
and the knowledge spillover impact is likely to be limited. Basic research
of the sort that is the mission of other federal agencies besides the
ATP is likely to create knowledge spillovers that are more diffuse and
slower to materialize.
3.
The interaction of market and knowledge spillovers
It will often be the
case that at least some of the firms that benefit from the knowledge spillover
will be competitors or potential competitors of firm 1. The extreme case
of this is pure imitation, where other firms copy the innovations of firm
1; more generally, firms making similar or related products may be able
to improve their products or lower their costs on the basis of things
they are able to learn as a result of firm 1's research. As shown in Figure
3, this complicates the picture in two ways. First, the introduction of
these cheaper or better products into firm 1's markets creates some additional
customer benefits, and some profits for these other firms, both of which
constitute social returns not captured by firm 1. These increase the spillover
gap.
Figure 3
At the same time that
this increased competition increases social returns, it will likely reduce
firm 1's profit from its own innovation. That is, the combination of knowledge
spillover with competitive interaction increases the spillover gap both
by raising the social return and lowering the private
return. Thus "pure" knowledge spillovers increase the social rate of return
to R&D, but they do so in a way that at least does not reduce the
private return. When knowledge spillovers are combined with competition,
however, the effect is likely to be an actual reduction of the private
rate of return. Put differently, the interaction of knowledge spillovers
and market spillovers aggravates the firm's appropriability problem: not
only does the firm create benefits that it cannot capture, but its own
profits from marketing its innovation are competed away. Understanding
this interaction has important implications for identifying which research
projects are likely to have large spillovers. In Section III.B, I discuss
the factors that economists have identified that affect firms' ability
to deal with this appropriability problem.
Finally, Figure 3
can also be used to illustrate the possibility that research effort of
any given firm can create a negative externality
for other firms. Suppose that the improved products of "other" firms in
Figure 3 came from their own research, rather than from a spillover of
knowledge from firm 1. In this case, there would still be a diminution
of firm 1's profits as a result of this new competition. This reduction
in profits of other firms is a negative spillover, just as the increase
of profits of other firms in Figure 2 is a positive spillover.
To make this concrete,
consider the market for anti-ulcer drugs. In the 1970s, the drug Tagamet
was introduced, which, for the first time, reduced the stomach's production
of acid rather than just neutralizing acid once produced. This was an
important medical advance that generated large social benefits and also
large expected profits for the firm that introduced it. Subsequently,
Zantac was introduced, a drug that accomplishes the same objective as
Tagamet, though with somewhat fewer side effects. The maker of Zantac
has made large profits, because its slightly superior performance has
allowed it to take much of the market away from Tagamet.
From a social point
of view, the introduction of Zantac had 3 effects. On the plus side, the
maker of Zantac has earned large profits, and consumers have gotten some
benefit from Zantac's superior features and price competition between
the two firms. On the minus side, the maker of Tagamet has lost
a large stream of profits that it otherwise would have enjoyed. Altogether,
it is quite possible that the incremental social value of Zantac has been
quite modest, despite the fact that its maker has earned large profits.
Hence, in this case, the private rate of return to innovation likely exceeded
the social rate. Given that significant research resources were devoted
to the introduction of this marginally valuable (from a social point of
view) innovation, it is quite possible that the social rate of return
to this innovation was actually negative.
More generally, the
introduction of a new technology will often make some previous investment
in R&D obsolete. Part of the profits to the innovator can be thought
of as being taken away from the previous technological leader. This is
a negative externality, i.e. it is a negative social effect of research
that is not considered when a firm makes its own R&D decisions. At
a purely theoretical level, it is possible that this effect dominates
the other two, so that the laissez-faire level of private R&D is too
high rather than too low. In reality, the empirical evidence is overwhelming
that such is not the case, i.e. the net effect of the positive and negative
externalities is positive.(9)
Nonetheless, the existence of this negative effect has some implications.
In particular, if we can identify situations where it is likely to be
unusually large, then we can surmise that these are situations where the
net spillover benefits are likely to be small or even negative, suggesting
that this would not be a good area for ATP funding.
C. Relationship
of Spillover Concepts to Existing ATP analysis
Spillovers are already
very much a part of ATP discussions and analysis, although different words
are sometimes used. In this Section, I will relate the terms and analyses
that are currently used to the spillover concepts as I have described
them.
1.
Broad-based economic benefits
One explicit criterion
of project selection is the creation of broad-based economic benefits.
Under this criterion, the ability of a proposed project to enable new
economic activity is evaluated. The significance of potential market applications,
and their impact on productivity, employment, output and quality of life
(if applicable) are considered. Applicants are asked to discuss timing
issues, and to explain why ATP assistance is needed, what difference it
will make, and why taxpayer support is justified. The overall incremental
benefits created by the project are compared to its overall incremental
costs. Although economic benefits include purely private benefits, and
thereby encompass much more than spillovers, this analysis is also closely
related to the kinds of impacts on productivity, employment and output
that determine the magnitude of market spillovers.
As shown in Figures
2 and 3, knowledge spillovers also lead, eventually, to economic benefits.
One way to think of this is to view market spillovers as creating direct
economic benefits, and knowledge spillovers as creating indirect
economic benefits. Thus, at least in principle, both of these effects
would be a part of what is currently analyzed under the rubric of broad
economic benefits.
2.
Enabling technology
The concept of "enabling"
technology is widely used as a general description of the mission of the
ATP, and as a criterion for discussing individual projects. I believe
that the notion of enabling technology can be related to the concepts
of market and knowledge spillovers, and the important interactions between
the two. There are a number of different ways in which a technology can
be thought of as enabling. In this subsection, I consider different ideas
of enabling technology that are used within the ATP, and how each relates
to the spillover concepts that I have elucidated.
Multi-use
technology. A multi-use technology is defined within the
ATP as "a technology that has many distinct applications." In the framework
that I have presented, a multi-use technology can be thought of as one
that generates many distinct paths of knowledge spillover. Referring to
figure 2, if the lower pathway that begins with "Other firms' knowledge"
being augmented by spillovers from the research of firm 1 is replicated
many times over, then firm 1 is generating multi-use technology. The many
different and distinct applications of a multi-use technology make knowledge
spillover likely, because the original developer of the technology is
unlikely to be able to pursue all of these distinct applications, suggesting
that others will likely pick up the idea and commercialize (and hence
profit from) many of the resulting applications.
One way a technology
can have multiple uses is where "proof of concept" is important. For example,
the attempt to develop a catalyst for a certain polymerization reaction
that is based on an entirely new mechanism could be a multi-use technology;
the successful demonstration of the validity of the new mechanism may
well allow others to develop new catalysts for a whole range of other
polymerization reactions. Another form of multi-use technology is where
improved performance of a specific component is the "bottleneck" preventing
higher performance in many different applications. The proponent wants
to make a quantum improvement in this component, and redesign one
of these applications to exploit the improved performance. But once the
improved component is available, all the other applications can be improved
as well. Thus a multi-use technology has significant knowledge spillovers
because it has a wide variety of distinct applications, not all of which
are likely to be implemented by the firm that successfully demonstrates
the first application.
The distinctness
of the applications is important. If I invent a better automobile windshield
wiper, one might argue that this is a multi-use invention, as it can be
used on every car, truck, and tractor in the world. But these are not
distinct applications, by which I mean no significant additional research
has to be done to adapt the idea to these different uses. There is little
to stop me from making all of these sales myself (assuming I have adequate
manufacturing capacity). In contrast, when there are numerous distinct
applications, the time and application-specific knowledge that it takes
to undertake the application-specific research necessary to implement
the generic idea in different areas will make it difficult for any one
firm to capture all of these areas. This makes spillovers likely.
Pathbreaking
technology. Another way in which a technology can be enabling
is to be "pathbreaking," defined as "a technology that induces revolutionary
change in existing fields or that promises to open up new fields of activity."
Whereas a multi-use technology can be thought of as one for which the
knowledge spillover impact is likely to be "wide," we can think of a pathbreaking
technology as one whose knowledge spillover impacts are "deep." That is,
the solution to certain stubborn technical problems can be expected to
open up a new line of technological developments, creating in the process
entire new markets or even new industries. It is extremely unlikely that
the firm that originally opens up this line will capture all or even most
of the economic benefits thereby created. As discussed below, for example,
the firm that invented the "CAT" scanner did not last long in the commercial
market, as subsequent products that built upon but improved the original
idea were marketed by other firms.
Infratechnologies.
Tassey (1995) defines "infratechnologies" as "a set of 'technical tools'
for making the entire economic process more efficient, or, in some cases,
possible in the first place." Examples given by Tassey of infratechnologies
include standards, scientific and engineering data, measurement and test
methods, production practices and techniques, and interfaces. Clearly,
infratechnology as relevant to the ATP is a narrower concept. The ATP
defines infratechnology as "technology that supports the R&D, production,
and business of entire industries."
In my view, infratechnologies
can be thought of as generating two kinds of spillovers. First, development
of measuring and testing methods, interfaces, and certain production practices
have elements of network externalities. That is, these technologies often
have features that depend on the establishment of standards that
are shared by multiple industry participants. It does me no good to develop
an interface unless many others are going to use it. Similarly, the value
of measuring and testing methods is greatly enhanced when the same methods
are widely used, so that test results can be shared and used as the basis
for market transactions. For the reasons discussed above, activities that
have this element of the creation of standards, with the attendant network
externalities, are likely to be underprovided by competitive markets.
The idea of infratechnologies
appears, however, to be broader than just standards. Another dimension
is the development of technologies that are essentially inputs
to the research process. Even without the issue of standards, the development
of certain kinds of scientific and engineering data, or the creation of
measuring and testing instruments, facilitate the research process. One
way to think of this is to view infratechnologies as inventions whose
"market" is the research process itself. That is, the customers are other
researchers, and the market spillovers come in the form of increases in
the efficiency of others' research programs. Now, to the extent that the
research process generally involves the creation
of spillovers, the generation of market spillovers that come in the form
of more efficient research ought to generate particularly large social
returns, since the research endeavors that benefit will typically go on
to generate further spillovers.
Overall, then, the
various notions of "enabling" technologies can be thought of as capturing
several specific mechanisms by which market and knowledge spillovers operate
and interact. As discussed in Section IV, understanding the significance
of these spillover pathways provides an analytical basis for evaluating
the spillover potential of proposed projects.
3.
Necessity of ATP support
Finally, an additional
element of the existing review process that relates to spillovers is the
necessity of ATP support. Conceptually, the existence of large spillovers
is one obvious explanation why a technically important project with significant
economic benefits might not be carried out without ATP support. Often,
the spillover connection is implicit rather than explicit: proponents
and/or reviewers will cite the diffuse and high-risk nature of the potential
benefits as reasons why private capital is not forthcoming, or note that
the project is not part of the proponent's core business.
III. REVIEW
OF ECONOMIC LITERATURE RELATING TO SPILLOVERS
A. Estimating
rates of return and the magnitude of spillovers
A possible excuse
for the delay between the time Alfred Marshall talked about spillovers
and the time economists made serious efforts to measure them is that they
are inherently difficult to observe. As Paul Krugman has noted, "knowledge
flows...are invisible; they leave no paper trail by which they may be
measured and tracked, and there is nothing to prevent the theorist from
assuming anything about them that she likes" (Krugman, 1991, p. 53). As
a result, empirical measurement of spillovers is necessarily somewhat
indirect. Most analyses take the form of measuring the innovative effort
or output of one agent or set of agents, and looking for a correlation
between this measure and the innovative output of another agent or set
of agents.
To make such an analysis
tractable and meaningful, one must identify which agents are the likely
recipients of spillovers from particular research efforts. This typically
involves developing a metric for measuring the "closeness" of different
agents -- either in terms of technological similarity, geographic proximity,
or economic relationships, such as vendors and their customers. To infer
the existence of spillovers from a correlation between the research effort
of one group of agents and the research output of other agents that are
somehow "close," it is necessary to control for (1) the innovative effort
of the second group, and (2) variations in "technological opportunity"
that might be affecting the productivity of research effort for both the
"spilling" and "receiving" agents, inducing a correlation between an agent's
research success and the effort of other firms that need not be related
to spillovers.
Studies of this sort
allow the calculation of the "excess return" to R&D investment, i.e.,
the difference between the rate of return calculated including the effects
of the investment on the recipients of spillovers, and the rate of return
calculated excluding spillover effects. Depending on the nature of the
study, this excess return or spillover gap may encompass knowledge spillovers,
market spillovers, or both. In general, the spillover gap is found to
be positive, suggesting that the negative competitive externality is generally
outweighed by positive effects of knowledge and consumer surplus externalities.
1. Measurement
of market spillover
The oldest line of
work focuses on spillovers embodied in products and measures closeness
using supplier-customer relationships. For example, Terleckyj (1974) looked
at industry data, constructing a measure of "borrowed" R&D for each
industry on the basis of the R&D of the industries from which it purchased
intermediate inputs, including capital equipment. He found that the productivity
effects of R&D in downstream industries implied an excess return to
industry R&D of 20% to 50% (compared to a private rate of return of
about 30%). This measure of market spillovers may also contain an element
of knowledge externalities, to the extent that the downstream firms are
engaged in their own research and benefit indirectly from the research
of their suppliers.
Scherer (1982 and
1984) took another cut at this problem. By examining patent data, he estimated
the fraction of inventions originating in each industry that
would be used by each industry. This allows the creation of a
"technology flow" matrix which can be used to allocate industrial research
by the industry in which it will be "used" regardless of the industry
in which it is performed. He shows that this "used" R&D variable is
more strongly correlated with industry productivity growth than is a variable
measuring R&D performed in the industry.
Mansfield, et al (1977)
used a case study approach instead of looking at aggregate industry R&D
statistics. They identified 17 specific innovations, and attempted to
estimate the actual cost and overall social benefits of each. In particular,
they took great care to analyze the impact of the innovations on customers,
and also on competitors. They did not, however, specifically seek to identify
knowledge externalities. For this group of innovations, the median private
rate of return was about 25% and the median social rate of return was
about 50%.
Bresnahan (1986) and
Trajtenberg (1990) have quantified the consumer surplus spillover from
mainframe computers in the 1960s and the CT scanner in the 1970s. Bresnahan
calculates that between 1958 and 1972 financial service firms paid $68
million for computing services, but received benefits equal to $200 to
$400 million. This difference between the cost of the computers and the
benefits they created is a measure of market spillovers, and suggests
that the social rate of return to this innovation was several times the
private rate. Trajtenberg calculates that the social rate of return to
improvements in CT scanners averaged between
180 and 350 percent per year, depending on how foreign R&D investments
are treated. While Trajtenberg does not calculate private rates of return,
approximately half of the producers, including EMI, the original innovator,
eventually left the business, apparently because of mounting losses.
2.
Measurement of knowledge spillovers
In my 1986 paper,
I used patent data for about 500 manufacturing firms to characterize the
"technological proximity" of all pairs of firms on the basis of the extent
of overlap of technological classification of their patents. I then constructed
a measure of the "spillover pool" for each firm, as the sum of all other
firms' R&D, weighted by their proximity to the receiving firm. I found
that the pool variable had positive effects on firms' patents, profits
and market value, all controlling for the firm's own R&D. For patents
-- a purely technological measure of research output -- roughly half of
the aggregate impact of R&D was in the form of spillovers, or, conversely,
the social productivity of research was roughly twice as great as the
private productivity. For economic measures of research output such as
profits, productivity and market value, I found that the spillover effect
was roughly half as large as the private return (10)
Interestingly, the
effect of the pool was found to be itself a function of firms' own R&D.
The more R&D a firm does itself, the more it benefits from spillovers
from others. With respect to profits and market value, firms that have
significantly less than the mean R&D level actually suffer a negative
effect from the spillover pool. This is interpreted as saying that both
knowledge and competitive externalities are present, with the former outweighing
the latter on average, but the latter outweighing the former for firms
that do little R&D themselves.
3.
Summary of estimates of spillover magnitudes
Griliches (1992, Table
1) summarizes the results of many of these studies. He concludes "R&D
spillovers are present, their magnitude may be quite large, and social
rates of return remain significantly above private rates." While all of
this work carries econometric limitations and presents only indirect evidence
that spillovers exist, the weight of the evidence does seem to be increasingly
convincing that spillovers create a large gap between the private and
social rate of return. There are two ways to look at this gap. In absolute
terms, it appears that the excess of the social
rate of return over the private rate --the rate of spillover -- is something
like 15 to 30 percent, with some estimates much higher than that. Another
way to look at this is relative to the private rate of return.(11)
Again, estimates vary somewhat, but spillovers seem to create a gap between
the private and social return that is equal to 50 to 100% of the private
rate of return. Note that the individual studies underlying these ranges
tend to emphasize either knowledge externalities or
market externalities. I can think of no study that, at a conceptual level,
is designed to capture both, although relationships between the two in
the data make it likely that each kind of study picks up some of the other
effect. Hence it is likely that these estimates have some tendency to
underestimate the combined effects.
B. Mechanisms
of Appropriation
In parallel to the
efforts to measure rates of return, economists have worked to understand
how firms respond to spillovers. U.S. firms spent about $100 billion of
their own money on R&D in 1995, so they obviously think that there
are significant private returns to capture. This does not mean, as discussed
above, that the social return is not even higher, but it does suggest
that understanding the mechanisms by which firms "appropriate" the returns
to R&D is likely to be helpful in understanding where and when spillovers
are likely to be large. From this point of view, spillovers are likely
to be largest when the mechanisms of appropriation are unavailable or
do not work well.
At a broad conceptual
level, there are 4 important ways that firms appropriate the returns to
R&D. (12)
First, to minimize knowledge spillovers, they can try to legally preclude
others from using knowledge that they create, through the use of intellectual
property protections such as patents, copyrights, and employment contracts
that attempt to prevent scientists and engineers who leave the firm from
using knowledge they take with them. Second, for certain kinds of new
knowledge, secrecy can be effectively maintained. Third, in some cases,
simply being first conveys sufficient advantage that an innovator can
capture a significant share of the benefits to innovation, even if the
knowledge is otherwise unprotected Finally, despite the simple model of
knowledge as a public good, economic exploitation of new knowledge often
requires other assets or abilities that may not be easily obtained or
duplicated. Investment in these "cospecialized" assets (Teece, 1986) may
allow an innovating firm to capture a larger share of the overall returns
to a new technology.
Intellectual property
protection is most successful with knowledge that can be easily described
and codified. Thus patents tend to be most effective in the chemical industries,
including drugs, and in some industries based on relatively simple mechanical
technologies (Levin, et al, 1987).(13)
Also, patents are generally viewed as more effective at protecting product
innovations than process innovations. Conversely,
secrecy is most effective in protecting tacit knowledge that is difficult
to codify (and hence difficult to copy), and is more useful in protecting
process innovations than product innovations.
First-mover
advantages possessed by an innovator derive from two primary sources.
First, being the first to market a new technology may allow a firm to
create customer loyalty that protects profits to some degree even if other
firms eventually are able to imitate the new product. Second, for production
technologies where "learning curve" effects cause production costs to
fall as production experience is accumulated, the first firm to market
may garner a cost advantage that is dynamically self-sustaining. That
is, the first firm acquires production experience first, leading to lower
cost; this lower cost allows the first-mover to maintain a large market
share which serves to increase production experience and lower cost further.
Finally,
the need for cospecialized assets, such as large-scale production capability,
a network of sales and service organizations, a reputation for reliability
within a line of products, or the ability to navigate a maze of regulatory
approvals necessary to market some products may allow some innovating
firms to protect themselves from the more serious competitive effects
of knowledge spillovers. Conversely, for products where these assets are
important, firms that do not possess them are
likely to have difficulty appropriating a large fraction of the returns
to their research. They will either have to license their technology to
a firm that does possess the other assets (giving up a significant chunk
of the profits in the process) or else knowledge spillovers make it likely
that they will soon face competition from other firms that can benefit
from the knowledge they have created, and which possess significant competitive
advantages in the marketplace.
A. The
Underlying Criterion for Project Selection
It is a generally
accepted criterion of public policy that expenditure programs should seek
to maximize the social rate of return of the expenditures they make. In
the case of the ATP, this basic objective is qualified by a number of
constraints, including a need to identify projects that produce enabling
technologies, that entail overcoming challenging technical difficulties
requiring a research agenda that pushes the state of the art of industrial
practice in the fields in question, and have the potential for significant
economic benefits to parties other than the project proponents. Among
projects satisfying these constraints, however, the ATP would like to
spend its funds to create the greatest possible social return.
Maximizing the social
return on the ATP's investment is complicated by the possibility that
ATP funds may be partially or wholly displacing private R&D resources,
implying that the social benefits of the research would have come about
without the ATP.(14)
The possibility of displacement induces a distinction between the social
rate of return to the project and the social rate of return to the ATP
expenditure. If ATP funds a project with a high social rate of return,
but in so doing largely displaces private funds, then the social return
to the ATP expenditure (the public rate of return on the government
investment) will be low despite the high social return to
the project. (15)
Thus the danger of displacement means that what the ATP must try to do
is fund projects that have a high social rate of return, and
a low probability that ATP funds are displacing private funds. Of course,
the ATP can never know for sure the extent to which it is displacing private
funds, and project proponents have an inherent incentive to understate
the likely extent of displacement.
The difficulty with
simultaneously seeking projects with high social returns and low probability
of displacement is that many factors pointing toward high social returns
also point towards higher likelihood of displacement; conversely, factors
pointing towards low probability of displacement may signal low social
returns. The reason for this connection is that the likelihood and extent
of private investment in a project are going to be affected by its private
rate of return. Any factors that tend to simultaneously increase
both the private and the social rates of return will tend to make the
danger of displacement high on projects with high social rates of return.
1. Minimizing
displacement by maximizing the spillover gap
The path through this
dilemma is to look for factors that cause the social and private rates
of return to diverge: the presence of such factors signals the possibility
that social returns may be high at the same time that the risk of displacement
is low. Strong likelihood of research spillovers is just such a factor.
Hence by trying to identify project proposals where the likelihood of
spillovers is particularly high, the ATP will fulfill its statutory mandate,
and do so in a way that will yield a high social return by minimizing
the extent of displacement.(16)
The relationships
among the social rate of return, the private rate of return and the danger
of displacement are illustrated by Figure 4, which graphs the social and
private rates of return for various hypothetical projects. Obviously,
there will always be tremendous uncertainty ex ante
about the private and social returns to a project. Conceptually,
Figure 4 should be thought of in terms of the expected
returns, i.e., the magnitude of the return if successful, times
the probability of success. The public sector seeks to maximize the expected
social return, and the private sector seeks to maximize the expected private
return.
Figure 4
Since projects higher
up on the diagram have higher social returns, in the absence of the displacement
concern and other constraints, the ATP would simply seek to find projects
that are as far up as possible. From the private sector point of view,
projects to the right (higher private return) are more likely to be funded,
all else equal. Of course, the likelihood of private funding for any particular
project will depend on its riskiness and the financial environment of
the project proponents. Although it is a gross oversimplification, for
the purposes of discussion I have arbitrarily divided the projects into
3 groups: "good" commercial prospects that are likely to be well-supported
by the private sector, "marginal" commercial prospects that are less likely
to be funded and may be funded at inadequate rates, and "poor" commercial
prospects.
All projects such
as "A," "B," and "C" that lie above the 45o line generate spillovers.
(Their social rates of return exceed their private rates.) If the ATP
seeks to choose projects with the highest social rate of return, then
project "C" is the most desirable of these projects, and ought to be the
prime candidate for funding. If society as a whole faced an all or nothing
choice among these projects, we might want to choose C, since its overall
social rate of return is higher. But it is likely that C will be funded
by the private sector, whereas it is likely that A and B will not be,
or will be underfunded. If the ATP ranks projects based on the "spillover
gap," then projects A and B would indeed be favored over C. Hence if we
want the ATP to generate high returns from projects that would not otherwise
be funded, then we would be better off looking at the spillover gap than
the overall social return.
Project D illustrates
the extreme version of this problem. This hypothetical project generates
high social and private returns, but its net spillovers are negative.
This might be the profile of a product like Zantac that is highly successful
but drives out a close substitute technology. If we were to seek to select
projects only on the basis of social returns, this project would rank
as higher than A, despite the fact that its private rate of return exceeds
its social rate. The government has no business funding this project,
given that its net effect on all parties, other than the firm performing
it, is negative.
In reality, of course,
we will have only coarse estimates of the social rate of return or
the spillover gap. The fact that these prospects can only be known
with great uncertainty strengthens the superiority of the spillover gap
over the social rate of return as a decision criterion. Although projects
like A do exist, there will in general be some correlation between the
private and social rates of return. For example, all else equal, both
rates will be higher for projects with higher success probabilities and
projects whose product (if successful) serves a larger market. If we focus
only on the social rate of return, then there is a danger that we will
fund projects that appear to have a high social rate of return, where
the only reason the private sector is not pursuing this project is because
its overall prospects (affecting both the private and social returns)
are being overestimated or overstated by the project proponents. If we
focus on the spillover gap rather than the apparent overall social rate
of return, we are less likely to step in to fund projects for which the
explanation for lack of private funding is that they are not really very
promising projects.
To state this point
slightly differently, the ATP decision process should recognize that its
information is imperfect, and that errors are going to be made. Further,
information that is available about a project ought to be examined not
only for what it says explicitly about social returns, but also for it
what it implies about the probability of errors
being made. In some cases, the "facts" being put forth to support the
likelihood of large social returns for a project are facts that equally
well support the likelihood of large private returns (e.g., a large market
for the resulting product). If these purported facts are true, then both
private and social returns from the project will be high, i.e. we will
be at points like C (or even D) in Figure 4. Now, the ATP cannot know
with certainty if the "facts" are really true, and cannot know why, if
they are true, the private sector would not fund the project on its own.
Logically, there are several possibilities: (1) the facts as presented
are actually false, i.e., the market is not really large or else the probability
of success is so low that the expected (social) net present value of the
investment is negative;(17)
(2) the facts as presented are true, and the private sector knows it and
would, indeed, fund the project with or without government help; or (3)
the facts are true, and there is some reason why the private sector will
not fund the project (or will not fund it adequately or in a timely way)
despite the potential payoff.
Some projects will,
of course, fall into category (3), but the ATP should be worried about
possibilities (1) and (2). This worry can be minimized by seeking a large
spillover gap, not just a large social return. If projects with apparently
high potential private returns are to be funded, there should be a careful
analysis of the reasons as to why the project is not being funded despite
its large potential payoff.
2. Commercialization,
business risk and the spillover gap
Point "A" in Figure
4 raises additional issues. This hypothetical project has good social
returns, but very low private returns. Because market size, success probability
and other factors tend to affect both private and social returns, projects
like "A" will come about only in cases where there are particularly strong
problems with appropriating the returns, leading to a large spillover
gap and low private returns. It is unclear what the ATP's attitude towards
a project like A should be. There is a large spillover gap, and a very
low risk of displacement, so this would appear to be a particularly good
funding prospect. The qualification of this conclusion rests on the observation
made above that the realization of spillover benefits from R&D projects
will likely be dependent to a large extent on successful commercialization
of the output. Projects like A with very poor commercial prospects are
not likely to be commercialized, even if technical success is achieved.
Hence the danger with funding projects like A is that few
spillover benefits will actually be achieved, because commercialization
will never occur.
Again, the realization
that information is imperfect complicates this analysis. Faced with a
proposal with apparently poor commercial prospects, the ATP will not know
for sure whether the project is really an "A" or a "B". In principle,
rational profit-maximizing companies obligated to share the cost of ATP
projects are not likely to propose projects like A. To the extent that
the cost-sharing burden is real, and the proponents can be trusted to
be acting to maximize profits, the ATP ought to ignore the danger of points
like A in its decision-making, seek to maximize the spillover gap, and
rely on the proponents to screen out projects where the private returns
are so low that commercialization is unlikely even if technical success
is achieved.
On the other hand,
to the extent that companies cannot be relied upon to screen out projects
like "A," then the ATP must be concerned both with seeking a large spillover
gap and expected private returns sufficient
to make commercialization likely. For example, R&D labs or research
divisions of large companies may not be disciplined effectively by their
management to pursue only commercially tenable projects. This means that
the ATP has to undertake the analysis necessary to ensure that proposals
from such organizations are not projects like "A" that are unlikely to
be commercialized and hence unlikely to produce significant spillover
benefits.(18)
This issue is important
because, holding constant the size of the market for the potential output,
factors that inhibit innovators' ability to protect their innovations
will simultaneously increase the spillover gap and
reduce private returns. Thus, as discussed above, a project proponent
that has the ability to manufacture and market a new product successfully
is more likely to appropriate the returns than one that would have to
license the technology to others, or else become a competitor in a market
where it does not have a historical market presence. From the point of
view of spillover analysis, the proponent's lack of manufacturing and
marketing ability ought to increase the ATP's interest in a project (all
else equal), because it increases the likelihood of spillovers. On the
other hand, the lack of these other abilities may make the likelihood
of commercialization so low that the spillovers will never come about.
There is no resolution
to this dilemma except to separate the two issues. Analytically, the spillover
gap is important, and factors that are likely to inhibit a proponent's
ability to capture the returns to its innovations make spillovers more
likely. At the same time, it may be true that, in combination with other
factors affecting the business risk of a particular project, limitations
on the ability of the proponent to capture the returns could eventually
tip the balance toward a decision that the project, despite its spillover
potential, has too low a probability of commercial success for ATP involvement.
B. Factors
Pointing Towards Large or Small Spillover Gaps
In practice, of course,
we cannot, ex ante, "measure" the spillover gap as shown in
Figure 4. But we can, based on the discussion in Sections II and III,
identify factors that will tend to be associated with high probability
or magnitude of spillovers. All of these will be a matter of degree, and
apply in a relative, "all else equal" sense. It will not be possible to
identify any particular characteristic that definitively identifies or
rules out spillovers. Nonetheless, a systematic analysis of these factors
should give a reasonable overall evaluation of a proposal's spillover
prospects.
Factors making market
spillovers larger or more likely:
- market in which
innovation will be used or sold is highly competitive
- lead time and learning
curves are not likely to give innovator strong market advantages
- technology is infrastructural,
i.e., other researchers are a significant component of the market for
the new technology
- output is product
innovation that would be difficult to patent or copyright
- cospecialized assets
are important in the relevant markets, and project proponents do not
possess important assets
- need for regulatory
approvals
- sales/service important
- reputation/market
presence important
- licensing of the
technology to others is likely to be important
- multi-use innovation,
where many uses are likely to be commercialized by others
- process technology,
proponents are small (or not) producers in relevant markets
- capital needs for
ultimate commercialization beyond proponents' reach
- other cospecialized
assets important (as above)
Factors making market
spillovers smaller or less likely:
- Proponents have
market power in the relevant markets
- Lead time and learning
curves can be expected to convey significant advantages on the innovator
if the project is successful
- output is product
innovation that can be protected by patent or copyright
- Proponents possess
important cospecialized assets
- Technical success
will lead to a large negative profit impact on another firm or firms
whose technology will thereby be made obsolete.
Factors making knowledge
spillovers larger or more likely:
- "multi-use technology"
- "proof of concept"
that would point the way for other researchers to try related ideas
in other applications
- key component that
will facilitate redesign and improvement of multiple distinct systems
using that component
- "pathbreaking"
technology: success will open an entirely new line of technological
development with apparently significant economic benefits
- subsequent technical
developments require expertise in applications technologies in which
proponents do not have relevant expertise (applies to both "multi-use"
and "pathbreaking" technologies
- useful knowledge
would be gained even if project fails to achieve its technical objectives
Factors making knowledge
spillovers less likely:
- output is process
innovation that can be kept secret, and project proponents can use in
their own production process
- project proponents
have special technical expertise that would position them to be the
most likely developer of many of the follow-on technologies
Factors making interacting
knowledge and market spillovers likely:
- output is "infratechnology:"
- technology
has attributes of a "standard" and thereby generates network spillovers
- output is a
product that would be sold to other researchers
- output is product
innovation that would be difficult to patent or copyright
C. Implications
for the Focused Programs
As discussed above,
there are some areas of technology where, in addition to the market and
knowledge spillovers, there is an additional externality due to the dependence
of profitability for each of a set of related projects on some "critical
mass" of projects being successful. The existence of an area of technology
where projects interact via these network externalities yields an argument
for government action to solve the coordination problem that might otherwise
prevent any of the different research projects from being undertaken.
Analytically, the
possible existence of network externalities can be seen as part of the
motivation underlying the creation of focused programs within the ATP.
Thus, the justification for the Component-Based Software program is not
that there is too little research effort devoted to developing new software.
Rather, there may be "enough" software development going on, but firms
are unlikely to expend significant resources on developing tools and capabilities
for the development of software "components," since the economic payoff
to the creation of such components is largely dependent on a wide range
of component availability, so that users can solve their overall applications
needs through the selection of such components rather than custom programming.
By creating a focused program, the ATP attempts to solve this coordination
problem, assuring each of the participants that the overall program activities
will create a reasonable chance that the component-based approach can
fly.
It is difficult, however,
to assess the validity and importance of the network spillover arguments
for focused programs in a general way. The mere observation that uncoordinated
action is not likely to be optimal does not, by itself, reveal what the
coordinated action should be. There is a danger that government intervention,
despite the best of intentions, can lead to "lock-in" of a certain approach
that is not in fact optimal. Further, although the theoretical possibility
of network externalities is real, markets do manage to solve many coordination
problems. In other words, to determine whether and to what extent the
network externality phenomenon would justify a focused program in a particular
technical area requires careful analysis.
By noting the connection
between network externalities and the possible government role in solving
the resulting coordination problem, I do not mean to suggest that this
coordination role is the only reason for the existence of focused programs.
There may be other benefits to focused programs besides addressing the
network spillover problem. The effect of knowledge spillovers may be magnified
by having a number of researchers working on distinct but related projects.
There may be administrative efficiencies to having a set of related projects,
and developing the in-house expertise to understand and manage them. Finally,
in a world of extremely imperfect information, focused programs may be
necessary to ensure that potential industry participants are sufficiently
aware of the ATP and what it does in order to maximize the quality of
the proposals that the ATP receives. Because of these other considerations,
the value of focused programs need not ultimately rest on the network
externality argument.
In any event, the
existence of focused programs does not eliminate the desirability of choosing
individual projects that are likely to yield high spillovers. To the extent
that the conditions listed above will be the same for the various proposals
in any given focused competition, they will not serve to discriminate
among the proposals in a focused competition. Other considerations will
differ, however, so that the need to identify the spillover potential
of individual proposed projects is not eliminated by evaluating them in
the context of a focused program.
V. INCORPORATING
SPILLOVER CONSIDERATIONS INTO FUTURE RESEARCH
The ATP is unique
among government technology programs in its support of R&D with clear
commercial focus for the sole purpose of achieving widespread national
economic benefits. It is thus imperative that research be undertaken to
document and understand the economic impacts of ATP funding. In addition,
while the ATP can benefit from spillovers from researchers working on
the economics of R&D, the value of such research to the program can
be increased by commissioning studies specifically designed to improve
our understanding of the R&D process in ways that would facilitate
better ATP decision-making.
The foregoing analysis
of what is known about the spillover process suggests a number of research
areas that should be supported by the ATP:
Better understanding
of the mechanisms of appropriation.
- Studies that
document the relative potency of specific appropriation mechanisms
across different industries or technological areas.
- Studies of particular
appropriation mechanisms, to understand better how they work, and
what kinds of firms or industries can or cannot use them.
Better understanding
of spillover pathways and social/private rates of return .
- Studies of the
role of market forces and market structures in determining the magnitude
of both market and knowledge spillovers.
- Studies of attributes
of technologies that affect the magnitude of market or knowledge spillovers.
Studies of the spillover
impacts of ATP-funded projects.
- Mansfield-style
analyses of the private and social rates of return of projects, including
impacts on customers and competitors.
- Analysis of knowledge
spillovers and their pathways, using both technological and market
data to identify impacts on the technology of other firms both in
and outside of the industry.
- Analyses that
test whether the market and technological factors identified above
as predictors of spillover potential are associated with larger spillovers
from ATP-funded projects.
- Statistical analyses
of funded firms, firms requesting but not receiving funding, and firms
not interacting with the ATP, to try to estimate the net impact of
ATP funding.
VI. CONCLUSION
In order to be effective
in achieving its statutory objectives, the ATP must try to determine which
projects proposed to it will generate large spillovers, and which will
not. Economists and other social scientists have identified certain aspects
of a project's technological and market environment that tend to be associated
with large or small spillovers. By incorporating the explicit analysis
of such factors into both project choice and evaluation of project impact,
the ATP can make better decisions
This task is complicated
by the interaction of a number of factors that cannot be disentangled
from each other. With some loss of important details, the problem can
be summarized as follows:
- The ATP wants
to fund projects that will have significant, broad-based economic benefits.
- The ATP wants
to fund projects with minimal "displacement" of private R&D funds.
- In general, projects
with significant broad-based economic benefits will tend to be those
that also offer the potential for significant private returns.
- Project proponents
have better information than the ATP about the prospects for private
funding, and also have an incentive to conceal this information.
- The realization
of spillover benefits is likely to be heavily dependent on commercialization
of the research results, making a clear path to commercialization important
to likely success.
Combining points 1-4,
the ATP should seek to fund projects that will have a significant economic
impact, and where there are specific attributes
of the project and its environment that make spillovers likely. Neither
of these conditions is sufficient in itself. Specific features of the
technology and the business and economic environment of the proposal that
make spillovers likely are crucial, both for ensuring that benefits from
this government expenditure will be widely felt, and for reducing the
likely extent of displacement. On the other hand, point 5 means that there
may be cases where the appropriability problems that create a large spillover
gap, when combined with other business aspects of the proposal, make the
likelihood of commercial success too low. To oversimplify, the ATP seeks
projects with large spillovers, but not projects where the spillovers
are so great that the remaining private return is insufficient to maintain
commercial momentum.
Thus there is an inherent
tension in the ATP decision-making process. We want project proponents
to be committed to a project, and to have reasonable prospects for commercial
success. A company that is going to do some research but leave it in the
laboratory is less likely to generate spillovers or large social returns;
hence projects that are unlikely to be commercialized do not achieve the
ATP's objectives. All else equal, however, anything that improves the
prospects for commercial success increases the expected profits or private
returns, thereby decreasing the spillover gap and increasing the likelihood
that ATP funding will displace private funds.
There is no way to
eliminate this tension, but recognizing it explicitly and separating the
issues of spillover potential and business risk should facilitate better
decisions. In evaluating business risk and the likelihood of successful
commercialization, it is appropriate that factors that support the proponent's
likely ability to appropriate the profits from the invention, such as
plans to protect inventions with patents, or the existence of a successful
marketing organization, would be considered a plus. Within the spillover
evaluation, however, it is equally appropriate that the feasibility of
patenting the output, or the presence of other appropriation mechanisms
such as a strong marketing arm, would be considered a negative factor
in determining the extent and likelihood of spillovers.
The ultimate project
funding decision in any given case will have to depend on these considerations
placed in the context of the overall proposal. For a project whose direct
output is likely to be patented, the ATP may still determine that the
overall spillover potential is large, if there
are other considerations pointing towards large spillovers, such as a
technology with strong generic attributes. In the absence
of other spillover indicators, however, a project that produces an easily
patented output should be viewed as low spillover potential and hence
low priority for funding. On the other hand, in cases wheresuccessful
patenting is unlikely, this is an indicator
of potentially large spillover potential. If this indicator, together
with other aspects of the technology, creates a strong case for likely
spillovers, then the decision to fund could turn on whether, despite the
lack of patent protection, other aspects of the proposal or its proponents
provide the basis for concluding that the business risk is manageable
and successful commercialization likely. If so, then the project is a
good funding prospect; if not, it should be a low funding priority because
of the absence of commercialization mechanisms.
This is an inherently
difficult and uncertain task, and it is one that requires an unusual combination
of technical, business and economic analysis. Perfect prediction cannot
be achieved, any more than it can be achieved for the purely technical
success of research. We know enough about spillovers to improve the ATP's
selection by a more systematic, explicit treatment of spillover effects.
Further research can improve and extend our knowledge of spillover phenomena
and how to measure them, in order to provide a firmer foundation for a
program with the mission, goals, and strategies of the ATP.
The empirical evidence
suggests that the average research project generates
spillovers. If the ATP can succeed in targeting projects with better-than-average
spillover potential, then it will generate large social returns that would
not otherwise have been achieved.
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ENDNOTES
1.
There may
also be costs that the firm does not consider. This issue is discussed
in Section II.
2.
The results
of empirical analyses of the magnitude of the gap between private and
social rates of return are discussed in section III.A.
3.
Economists
use the term "consumer surplus" to describe the value that the purchasers
of a product derive from a product minus the price paid for it. If the
price of a product falls, consumers enjoy greater consumer surplus from
its consumption. If the quality of a product rises, and the price does
not rise commensurably, there is a similar increase in consumer surplus.
Thus what I am calling the "market spillover" amounts to an increasing
consumer surplus.
4.
The term
"network spillover" is chosen because the different related research projects
are like the different users of a network. The value of a network to any
one participant is an increasing function of the number of participants;
here the expected value of any one research project is an increasing function
of the number of different projects undertaken.
5.
In some
cases, an innovating firm may not be in a position to utilize its new
technology, but will need to license or sell the technology to another
firm before the product or process can be implemented. In this case, imperfections
in the licensing market will generally result in an additional spillover
to the licensing firm.
6.
Typically
firm 1 will have been earning profits and consumers gaining benefits before
the R&D was performed; strictly speaking the returns are the increased
profits and increased consumer benefits. The figure ignores this
for simplicity.
7.
Typically,
the other firms would also be doing R&D of their own. The spillover
would consist of the incremental profits and consumer benefits
created when other firms' research benefits from the knowledge spillover.
Again, this complication is ignored simply to keep the picture clear.
8.
Estimates
of the lags between basic research and its economic impact range from
5-8 years (Mansfield, 1996) to 15 years or more (Adams, 1990)
9.
See Section
III.A.
10.
At the mean
of the data, the private return was about 30% and the social return about
45%.
11.
Studies
that estimate the highest social rates of return also tend to estimate
high private rates. Hence the ratio of social to private may be a more
robust indicator of the general pattern of results.
12.
For more
extensive discussion of these issues see Levin, et al, 1987, and Teece,
1986.
13.
This is
probably a combination of effects deriving from ease of obtaining the
patent with effects related to ease of enforcing against infringement.
If I synthesize a molecule that has never before existed, it is presumably
relatively easy to satisfy the "novelty" standard necessary to obtain
a patent, and also relatively easy to prove that someone else selling
the same molecule has infringed. Conversely, it may be hard to show that
a complex electronic or mechanical system is or is not substantially different
from what has come before.
14.
Both third-party
surveys sponsored by the ATP and a recent study by the General Accounting
Office (GAO) found that company opinion held that the great majority of
ATP-funded projects would not have been done or the project schedules
would have been slower and achieving goals delayed without ATP funding.
15.
Note that
even if ATP funding accelerates the project, partial displacement could
still be going on. If the private proponents would have spent $500,000
per year, and the budget with ATP support is $600,000 with 50/50 cost
sharing, then the project is being accelerated, but $300,000 in public
funds are producing only a $100,000 increase in research effort. Each
ATP dollar corresponds to only 33 cents of increased project funding.
16.
There are,
of course, other factors that might cause projects with high social returns
to be underfunded by the private sector. By the same logic, funding projects
where these other factors are present would yield high social returns.
17.
This is
not to say that ATP should avoid high-risk projects! What I am saying
here is that there are some projects for which the true chances for success
are so low that the expected social return (payoff if successful times
success probability) is less than the cost.
18.
A particular
case of proposals that might ignore the need for commercialization potential
would be proposals from non-profit organizations. It is for this reason
that the ATP does not entertain projects whose lead proponent is not a
for-profit firm.
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Date created:
December 1996
Last updated:
April 12, 2005
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