Econometric Tests of the Market Structural Determinants of R&D Investment: Consistency of Absolute and Relative Firm Size Models

This paper examines how the estimated coefficients in firm-level tests of the market structure-R & D hypothesis can be used to determine the effect of market restructuring on expected industry R & D. A theoretical taxonomy is illustrated with a simple single equation econometric model, and this example illustrates that even if the coefficients on the market power variables are significantly positive, market restructuring to reduce market concentration may increase expected industry R & D. OUR STOCK of hypotheses about the determinants of privately financed research and development (R & D) contains two logically independent classes-those that address the influence of the firm's absolute size and those that address the structure of the market in which the firm operates. Normative conclusions reached from tests of these hypotheses accordingly may prescribe the optimal firm size for performance of research in two different and potentially conflicting senses. The former hypotheses lead us to search out an optimal absolute size. The latter point to an optimal level of concentration in the market, and thus a preferred firm size relative to the market. But firm size, market size, and market share are linked by an identity. Given that we test our hypotheses about absolute and relative size independently-often using firm-level data for the one, industry-level data for the other-we have no assurance that the implied optima are consistent, either in general or in any particular market. In this note, we examine this consistency problem in the context of an econometric model of the determinants of research and development expenditures. The prevailing theory of the determinants of R & D includes independent hypotheses pointing toward both market structure and prevailing firm size as important influences. (See Scherer 1980, chapter 15 for a detailed discussion of these hypotheses.) For example, market structure may affect R & D performance by determining the firm's prospect for appropriating cash flows imputable to its innovative effort. If the arm's-length financing of investments in R& D is subject to failures in the capital market, then market structure affects the firm's capacity to undertake R & D through the amplitude of its cash