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Incentives to firms: do they affect the output of the innovation process?
There is general consensus among economists that market mechanisms fail to provide the socially optimal level of R&D spending, basically because private firms are not able to fully capture all the profits arising from the results of their R&D activity. Government intervention in this area is thus justified from an economic point of view by the market failure aspect of R&D: because the social returns to private R&D are often higher than the private returns, some research projects would benefit society but would be privately unprofitable. By lowering the cost to the firm, a subsidy can make these projects profitable as well. A somewhat related economic argument might also apply to fixed investment since the existence of financial constraints can lead to a suboptimal capital accumulation level which in turn could be corrected by the implementation of appropriate incentive schemes.
Providing convincing evidence on the direct effect of public subsidies on fixed and R&D investment is obviously a very important issue since both types of firm activities are found in the literature to be major determinants of firm innovation activities and ultimately of a country’s growth prospects. Yet, this evidence is not conclusive. It remains open whether it is the effect of subsidies on innovation outputs—as opposed to innovation inputs—what matters most. The ability of incentive schemes to allocate funds to the highest return projects should clearly be at the centre of the literature, but there is little direct evidence on this issue. More specifically, we do not know much about the effect of public subsidies on the pace of technological progress, although the role of intermediaries—including public bodies—in selecting entrepreneurs with the best chances of introducing new products or processes is a key mechanism through which GDP growth is affected.