PUBLIC SUBSIDIES FOR INDEPENDENT RESEARCH: New study suggests formula for breakthrough innovations

Subsidies for research, rather than helping small firms bring innovations to market, will maximise the impact of new technologies on economic growth, according to a new study published in the October 2017 issue of the Economic Journal.

Cutting the cost of commercialising an innovation may lead to more entrepreneurial activity, but at the same time it reduces the likelihood of pioneering inventions by entrepreneurs, the study shows.

''Our results suggest that the recent tendency for governments in industrialised countries to cut entry costs for business – through cheap loans, for example – is likely to lead to more entrepreneurship but fewer breakthrough inventions, generating fewer benefits for society in terms of economic growth'', says Lars Persson, professor of economics at the Research Institute of Industrial Economics in Stockholm.

He adds: ''Large established firms are also likely to respond to existing policies by choosing research and development (R&D) projects with a lower risk, leading merely to incremental innovations, our study reveals.''

The cost of starting a new business declined by more than 6% per annum over the period 2003-08, and the decline among OECD countries has been even more dramatic, according to the World Bank. At the same time, the US Small Business Administration approves billion of dollars in loans and guarantees to small businesses every a year.

''Our research suggests that these policies can be counterproductive'', Professor Persson says.

Entrepreneurship and innovation have long been recognised as key determinants of economic development and growth. In addition, firms of very modest size have been responsible for most pioneering breakthroughs, and new entrants without a commitment to accepted technologies have been responsible for a substantial share of really revolutionary industrial products and processes. Meanwhile, large established firms tend to generate more routine R&D and incremental innovations.

The new study shows that entrepreneurs have incentives to choose projects with high risk and high potential, in order to reduce expected entry costs.

The research suggests that when designing entrepreneurial policies, policy-makers should take account not only of firms'' incentives to undertake R&D projects, but also of the type of research projects they expect to conduct when those policies are implemented.

In particular, the study shows that policies designed to reduce entry costs could stimulate entrepreneurship, but also stimulate entrepreneurship that takes too little risk from a social point of view.

A significant decrease in the cost of commercialisation will lead to more entrepreneurial entry, but at the same time to a reduction in the likelihood of breakthrough inventions.

The study also illustrates how entrepreneurship policies might need to be adapted to the specifics of the product market. Policy-makers should complement R&D subsidies with a tax on entry in markets characterised by a low degree of product differentiation, but may complement the R&D subsidy with a subsidy of entry in product markets with a high degree of product differentiation.

''We show how independent researchers choose research projects with higher risk profiles than do incumbents'', Professor Persson says.

''We also show that society may prefer firms to undertake more risky R&D and, therefore, that diversity of R&D in the form of risk-taking entrepreneurial firms can be beneficial to society.''

''Why Entrepreneurs Choose Risky R&D Projects – But Still Not Risky Enough'' by Erika Farnstrand Damsgaard, Per Hjertstrand, Pehr-Johan Norback, Lars Persson and Helder Vasconcelos is published in the October 2017 issue of the Economic Journal. Erika Farnstrand Damsgaard, Per Hjertstrand, Pehr-Johan Norback and Lars Persson are at the Research Institute of Industrial Economics in Stockholm. Helder Vasconcelos is at the University of Porto.