Increasing the productivity of workforce is the key to higher living standards and stronger economic growth in the future.
Evidence shows that investments in Research and Development (R&D) have large payoffs in terms of industrial growth. Investments in R&D are estimated to account for more than half of the output increase per person. Increasing the productivity of workforce is the key to stronger industrial growth, national development, and higher living standards in the future. R&D yields new products, improving the quality of life, and new processes, enabling companies to reduce costs of production and become more competitive. Maintaining or increasing R&D effort is essential if a nation is to increase the rate of productivity growth and improve living standards.
The largest part of R&D is funded by private industry. When small entrepreneurs see an opportunity, they raise funds and take their chances on an innovative idea. Large companies spend billions on R&D labs in order to develop new products and processes. Private companies know their markets and the workers who are to produce the products. As they risk their own funds, it gives them a strong incentive to avoid costly failures.
The government has an important role in the promotion of science and technology. In today's complex and competitive world economy, promoting the progress of science goes beyond simply the granting of patents. First, successful R&D in private companies depends upon the flow of new ideas and trained people stemming from basic research and pre-commercial R&D. Government support for these activities is vital. Second, the government sponsors much applied research to improve its own capabilities in such areas as national security, health, and transportation. The government can then help transfer technologies developed for its own use to the private sector.
The private sector on its own will not commit the level of resources to R&D that is best for society or even for the individual firms. A firm bases its investment expenditures, including those on R&D, on the expected return on an investment to that firm. Because firms realize only a portion of the total returns to an investment in R&D, they will not invest enough from a societal standpoint. R&D is a unique input in the production process. Its results can spread quickly throughout the economy, with applications far beyond those imagined by the original researcher - the so-called "spillover" effect. Spillovers mean that an individual firm or innovator will realize only a fraction of the total returns to an innovation; that is, the innovation yields benefits to others for which the original researcher is not fully compensated.
Lasers and transistors are now a part of everyday life. The inventors of the laser probably had no idea that it would eventually be used for removing cataracts or for playing music in a compact disc player. Likewise, the American physicists who invented the transistor at Bell labs in 1948 could not have imagined that their invention would be used today in radios, computers, spaceflight and guided missiles, and countless other electronic devices. In both cases, even if the inventors' imaginations did reach such heights, today they receive no additional monetary benefit for the large advantages that society reaps from their insights.
Sometimes the spillovers are far more subtle. The discovery of nylon showed that it was possible to create artificial fibers with remarkable properties - and this knowledge affected the direction of research efforts applied by thousands of other researchers.
The consequences of the existence of important spillovers is that private firms will not invest enough in R&D from a national perspective. This point is not merely theoretical: many studies have demonstrated that investments in R&D yield high returns to investors and even higher returns to society. One recent review of econometric studies concluded that the average private rate of return to an innovation seems to be between 20 and 30 percent, while the social rate of return is closer to 50 percent. An earlier, extensive, case-study approach found that the median private return to the innovations studied was 25 percent, while the median social rate of return was 56 percent. While estimates of the rates of return are just that - estimates - a wealth of studies over the past two decades have confirmed these high private returns and even higher social returns. Table 2 highlights the results of some of these studies.
Continued advances in R&D and technology are crucial to ensuring and increasing economic growth and national development. Many studies have shown that while returns to a firm from investing in R&D are high, returns to society are even higher as new ideas are applied to areas far beyond what the innovator initially imagined. However, such spillovers imply that private firms will not invest in enough R&D from a national perspective. The government can step in to fill the gap between the private level of R&D investment and the level and types of R&D investment that are best for the nation. Moreover, the nation benefits not just from the results of government-sponsored projects, but also because national R&D expenditures seem to stimulate additional private R&D expenditures.