The theoretical basis for government’s role in market activity lies in the concept of market failure. As mentioned before, market failure is typically attributed to monopoly power, imperfect information, externalities, and public goods. For example, the balance between
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monopoly power and economics of scale is continually being assessed through antitrust legislation. Explicitly asserting market failure to justify government’s role in R&D activity, however, is a relatively recent phenomenon in public policy.
Market failure, particularly technological or innovation market failure, results from conditions that prevent organizations from fully realizing or appropriating the benefits created by their investments. This situation happens when conditions prevent the R&D- investing firm’s full appropriation of the benefits from a marketable technology developed through the R&D process.
Patents are one of the more viable mechanisms for helping innovators reap the benefits of their research. Nevertheless, patents are imperfect and, typically, other firms in the market or in related markets will realize some of the profits from the innovation. Consequently, the R&D-investing firm will calculate that the marginal benefits it can receive from a unit investment in R&D will be less than what could be earned if all benefits could be fully appropriated. As a result, an underinvestment in R&D ensues with respect to what would have been optimal from a social perspective. Stated another way, the R&D-investing firm may determine that its private rate of return fails to exceed its private “hurdle” rate (i.e., the firm’s minimum acceptable rate of return); it may, therefore, decide against undertaking socially valuable R&D if it is not economically valuable for the company. The result may be a shift of R&D investments into second-best technological solutions from the societal perspective.
Several factors can lead to a firm’s perception that its expected rate of return will fall below its hurdle rate:50
• High technical risk may cause market failure because, even when the firm is “successful,” the private returns may fall short of the private hurdle rates.
• High technical risk can relate to high commercial or market risk when the requisite R&D is highly capital-intensive. The investment may require too much capital for a firm to feel comfortable with the outlay; therefore, the firm may not make the investment, even though both it and society might have benefitted more if it had. • Many R&D projects are characterized by a lengthy time interval until a commercial
product reaches the market.
• Not uncommonly, the scope of potential markets is broader than the scope of the individual firm’s market strategies, so the firm may not perceive economic benefits from all potential market applications of the technology.
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• The evolving nature of markets requires investment in combinations of technologies that, if currently extant, would reside in different, nonintegrated industries.
Because such conditions often transcend the R&D strategy of individual firms, such investments will likely remain unrealized.
• In some situations, the technology may make assignment of intellectual property rights difficult.
• Industrial structure can raise the cost of market entry for applications of the technology.
• In some situations, the complexity of a technology makes buyer-seller agreement about product performance costly.
These factors, individually or in combination, can create barriers to innovation and, therefore, because of the technological market failure, lead to a private underinvestment in R&D. As a result, frequently a role for government is to support the development of technologies that have large spillover benefits (e.g., by providing information that will be valuable to numerous parties and will lower their costs of further R&D and commercialization) or are characterized by high risk but high potential return.
The main criticism aimed at government-supported R&D is that the government is then picking the next generation of technologies. Because resources are limited, the government develops and implements criteria by which it selects technologies and processes to fund. The question remains, however: Does the government have better information than the private sector on the potential success, both technical and economic, of technological alternatives? The persistence of this question has meant that the role of government has traditionally been focused on basic, precompetitive R&D, from which knowledge spillovers are noncontroversial. Basic R&D has historically been considered to have many attributes of a public good; hence, there is a clear role for government in promoting the optimal social level of basic R&D.
In the past, the government has hesitated to venture into areas of applied research that are too close to commercialization of technology. However, this hesitance has been eroding in recent years because of concerns that, without government funding, the movement of new technologies from the laboratory or university to commercial products will end in the “valley of death” (i.e., the time span of negative cash flow in the life cycle of a technology).51
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