The Handbook of Technology and Innovation Management

15.2. Research and Development as Investment

From the perspective of investment theory, innovation investments have a number of characteristics that make them different from ordinary investment. First and most importantly, in practice 50% or more of the R&D portion of this investment is the wages and salaries of highly educated scientists and engineers. Their efforts create an intangible asset, the firm's knowledge base, from which profits in future years will be generated. To the extent that this knowledge is 'tacit' rather than codified, it is embedded in the human capital of the firm's employees, and is therefore lost if they leave or are fired.

This fact has an important implication for the conduct of R&D investment. Because part of the resource base of the firm itself disappears when such workers leave or are fired, firms tend to smooth their R&D spending over time, in order to avoid having to lay off knowledge workers. This implies that R&D spending at the firm level typically behaves as though it has high adjustment costs (Hall, Griliches, and Hausman, 1986; Lach and Schankerman, 1988), with two consequences, one substantive and one that affects empirical work in this area. First, the equilibrium required rate of return to R&D may be quite high simply to cover the adjustment costs. Second, and related to the first, is that it will be difficult for empirical studies to measure the impact of changes in the costs of capital on such investment, because such effects can be weak ...