An important problem managing technology is the financing of technological advance and innovation. We can often read about firms' technology managers, including interestingly, those of large firms, reporting that they have more projects that they would like to undertake than funds to spend on them. We can think of a number of reasons for this phenomenon, such as low expected returns due to an inability to capture the profits from an invention, the uncertainty and risk associated with the project, and over-optimism on the part of managers. Research to date has not fully settled the question of how much weight to put on each of these factors in explaining the phenomenon nor on the extent of the funding gap, although there seems to be more robust evidence on the gap in the case of smaller firms.
Interestingly, economists have long held the view that innovative activities are difficult to finance in a freely competitive market. Support for this view in the form of economic-theoretic modelling is not difficult to find, and the idea itself was often alluded to by Schumpeter – not really surprising. The argument proceeds as follows. The primary output of innovation investment is the knowledge of how to make new goods and services, and this knowledge is nonrival, meaning that use by one firm does not preclude use by another. To the extent that knowledge cannot be kept secret, the returns on investment in knowledge cannot be appropriated by the firm undertaking the investment, and therefore such firms will be reluctant to invest, leading to the underprovision of R&D and other innovation investments in the economy. This argument has been developed, tested, modified, and extended in many ways.
Moreover the empirical support for the basic point concerning the positive externalities created by research is widespread, mostly in the form of studies that document a social return to R&D that is higher than the private return. This line of reasoning has been widely used by policymakers to justify such interventions as the intellectual property system, government support of innovative activities, R&D tax incentives, and the encouragement of research partnerships of various kinds. But what if entrepreneurs face financing constraints generated by asymmetric information on the quality of the innovation project? Entrepreneurs are better informed about the quality of their own projects than are lenders, whose valuation of projects reflects average project quality. This may raise the rate of return required by lenders so high that it becomes unprofitable for an entrepreneur without sufficient internal funding to undertake an economically viable project.
Can we in this case justify public intervention in the form of public funding to alleviate the problems caused by adverse selection. Perhaps more interestingly, what are the effects of public funding on capital costs related to innovation projects as well as on the incentives of market-based financiers to finance innovation projects – given that an entrepreneur's observation of receipt of a subsidy for an innovation project actually constitutes an informative signal as to the quality of the project as perceived by market-based financiers. These are crucial questions, and recent theoretical research has made some progress in answering them. In particular, under certain plausible conditions, public R&D subsidies can reduce financing constraints. And, if market-based financiers can observe that a project has received a public subsidy, then this observation increases the success probability of the project in the eyes of the market-based financier, which reduces the cost of external capital for subsidized projects. These are interesting and encouraging results and clearly indicate that further research in this area is well motivated as well as highly rewarding. |