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A unified theory of public basic research

Summary:
"Applied research directed towards immediate social benefit is essential. So is basic research. It increases our wealth of knowledge – an end in its own right – and generates transformational technologies. Basic science yields fantastic returns on investment, but we cannot predict which investment will pay off, or when. It took almost a century to apply the theory of relativity to correct the time signals from satellites, thus enabling the global positioning functions on smartphones." (Ramakrishnan 2017) Venki Ramakrishnan, Nobel laureate and president of the Royal Society, argues that at least some basic research is essential. But how much basic research is desirable from a national and global perspective, and which industries or areas should be the targets of this research?

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"Applied research directed towards immediate social benefit is essential. So is basic research. It increases our wealth of knowledge – an end in its own right – and generates transformational technologies. Basic science yields fantastic returns on investment, but we cannot predict which investment will pay off, or when. It took almost a century to apply the theory of relativity to correct the time signals from satellites, thus enabling the global positioning functions on smartphones." (Ramakrishnan 2017)

Venki Ramakrishnan, Nobel laureate and president of the Royal Society, argues that at least some basic research is essential. But how much basic research is desirable from a national and global perspective, and which industries or areas should be the targets of this research? These issues have always occupied policymakers, but they have received particular attention in the low-growth environment of recent years, which has been also a period of digital transformation.

Basic research generates the new knowledge and understanding needed for innovation. It is well-known at least since Nelson (1959) and Arrow (1960) that basic research has the characteristics of a public good, and so it needs public engagement. Indeed, the major part of basic research is funded and provided by national governments (Akcigit et al. 2013, Gersbach et al. 2019b) that want to foster private innovation in the domestic economy.1

Our investigation starts with the observation that the national costs and benefits associated with these investments critically depend on a country’s integration in the world economy. On one hand, innovative domestic firms benefit from supplying products to the world market, and their profits depend on competition in their industry (and thus on innovation in the rest of the world). On the other hand, innovation combines insights and ideas from basic research with industry-specific know-how (Nelson 1959, Arrow 1962, Akcigit et al. 2013, 2016). This know-how is mostly acquired through production, and there is a rationale for a close proximity of innovation and production activities (Pisano and Shih 2012, McKinsey Global Institute 2012). 

A country’s current specialisation in international trade will therefore affect its potential to innovate in different industries. Ceteris paribus, the more advanced and the more diverse the domestic economy, the higher its potential to innovate and the larger the domestic gains from investments in basic research. 

The left bar of Figure 1 shows the fraction of country-industry pairs with revealed comparative advantage (RCA) in patenting greater than one when RCA in exporting is smaller than one (Balassa 1965). The right bar shows the fraction when RCA in exporting is greater than one.

Figure 1 Fraction of country-industry pairs with revealed comparative advantage in patenting greater than one, 2013

A unified theory of public basic research

Source: Exports from CEPII BACI. Patents from the OECD 'Patents by Technology' dataset.

We asked what these interdependencies would imply for basic research investments at national levels and worldwide (Gersbach et al. 2019a). To do this, we developed a multi-country, multi-industry general equilibrium model with endogenous innovation and international trade that could rationalise the distributions of basic and applied research, and the national shares of global profits, in today’s world. 

We were able to show that from a global perspective investments in basic research by national governments are inefficient along three dimensions: 

  1. There is typically too little global investment in basic research. 
  2. Basic research is too heavily concentrated in industrialised countries. 
  3. Basic research is potentially insufficiently directed to support innovation in complex high-tech industries. 

These findings suggest that coordination among countries, for example among EU members, could lead to welfare-improving policies. 

The model

We used a static version of a multi-country, multi-industry expanding varieties model following Romer (1987, 1990), with basic and applied research, international trade, and knowledge diffusion. The innovation process is at the heart of our framework, and its model representation is guided by facts that are important for the understanding of basic research in a global economy: 

  • Basic research is a public good. And it is, to a large extent, provided by national governments. 
  • There are important cross-country knowledge spillovers. National governments invest in basic research because it has important local effects on innovation (Jaffe 1989, Jaffe et al. 1993, Audretsch and Lehmann 2004), but ideas from basic research will eventually diffuse globally.[2] 
  • Insights from basic research are typically embryonic. They need to be commercialised in private applied research to harvest the gains from basic research.3
  • Applied research combines the insights from basic research with industry-specific know-how. Countries tend to innovate more in industries with stronger domestic production. This has important feedback effects on countries’ incentives to invest in basic research, especially as it is difficult to predict which insights will emerge from basic research, in which industries these insights will be most valuable, and when they will occur. And while there is some scope for targeting basic research efforts to certain industries, for example by prioritising particular fields of science (Cohen et al. 2002), this targeting is imperfect.4

Therefore investment decisions made by national governments are interdependent. Basic research policies and innovation in the rest of the world will yield positive spillovers to the domestic economy and also feed back into the gains from innovation in different industries. To obtain a coherent picture of public basic research in a global economy, we used a multi-country, multi-industry general equilibrium framework with international trade. We chose a Ricardian free-trade environment that allowed us to isolate frictions arising from the innovation process. In the model, countries differ in their economic development, which captures anything that fosters a country's economic prosperity such as technologies, human capital, or institutions. In equilibrium, richer countries are more diversified in terms of their exports, and poorer countries tend to be systematically excluded from exporting complex goods (Imbs and Wacziarg 2004, De Benediktis et al. 2009, Cadot et al. 2011, Hausmann and Hidalgo 2011, Parteka and Tamberi 2013, Schetter 2019). This has important implications for basic research policies. 

Key results

The equilibrium in our economy is consistent with key facts on innovation in today’s world. In our model, governments of industrialised countries face both higher costs and higher benefits. 

Wages for scientists are higher in industrialised countries, as the outside option of working in production yields higher wages in these countries. On the other hand, the domestic economy is more diversified, which allows it to commercialise ideas in a large set of industries.5

Scientists are also potentially more productive in more developed economies. We show that more developed countries invest a higher fraction of their GDP in basic research as long as basic research is at least as skill-intensive as production. In addition, thanks to their broad industrial base, these countries benefit more from knowledge spillovers from the rest of the world, and thus are highly innovative. Their high level of innovation allows these countries to capture a disproportionate share of global profits, as we find in the data (see Figure 2).

Figure 2 Basic research investments relative to GDP, 20-year average from 1995 to 2015

A unified theory of public basic research

Source: OECD dataset "Main Science and Technology Indicators". GNI and GDP is 2015 OECD data.

We compared investments by national governments to the optimal solution of a global social planner, that is to create optimal policies with international coordination. Coordinated basic research policies would yield welfare improvements along three dimensions. 

  1. The social planner would distribute investments in basic research more equally across countries. The basic intuition is that developing countries invest little in basic research because their domestic economy is not effective in science-driven innovation, implying that they suffer more from knowledge spillovers to the rest of the world compared to industrialised countries. 
  2. In spite of the high concentration of basic research investments in industrialised countries, global investments may not be targeted sufficiently towards high-tech industries. This counterintuitive result emerges from the endogenous distribution of basic research investments across countries, and their optimal targeting of basic research investments to industries. It is rooted in the importance of tacit know-how for innovation and the fact that industrialised countries are more diversified, and tend to successfully export varieties in both simple and complex industries, while developing countries tend to systematically specialise in simpler industries. Interestingly, inefficient targeting is particularly likely to occur if new industries – or products, for that matter – are relatively complex high-tech industries. 
  3. Aggregate investments are typically too low when each country decides on basic research investments individually. 

Conclusion

Our work shows how international coordination of basic research can improve welfare through higher aggregate investments, and a more efficient distribution of basic research investments across countries and industries. This offers a global perspective on the Bayh Dole Act that incentivises university researchers to become more engaged in the commercialisation of their work. 

These incentives arguably lower researchers’ productivity in terms of pure science. Yet, they may be welfare-improving, as they allow countries to capture a larger share of the gains from their own basic research, which may contribute to closing the gap to globally efficient levels of investment in basic research.

References

Aghion, P and P Howitt (1996), "Research and development in the growth process", Journal of Economic Growth 1(1): 49–73. 

Akcigit, U, D Hanley, and N Serrano-Velarde (2013), "Back to basics: Basic research spillover, innovation policy and growth", NBER working paper 19473. 

Akcigit, U, M A Celik, and J Greenwood (2016), "Buy, keep, or sell: Economic growth and the market for ideas", Econometrica 84(3): 943–984. 

Arrow, K (1962), "Economic welfare and the allocation of resources for invention", in Universities-National Bureau Committee for Economic Research and Committee on Economic Growth of the Social Science Research Council (eds), The Rate and Direction of Inventive Activity: Economic and Social Factors, Princeton University Press: 609–626.

Audretsch, D B and E E Lehmann (2004), "Mansfield's missing link: The impact of knowledge spillovers on firm growth", Journal of Technology Transfer 30(1-2): 207–210.

Bahar, D, R Hausmann, and C A Hidalgo (2014), "Neighbors and the evolution of the comparative advantage of nations: Evidence of international knowledge diffusion?", Journal of International Economics 92(1): 111–123. 

Balassa, B (1965), "Trade liberalisation and 'revealed’ comparative advantage", The Manchester School 33(2): 99–123.

Cadot, O, C Carrère, and V Strauss-Kahn (2010), "Export diversification: What’s behind the hump?", Review of Economics and Statistics 93(2): 590–605. 

Cohen, W M, R R Nelson, and J P Walsh (2002), "Links and impacts: The influence of public research on industrial R&D", Management Science 48(1): 1–23. 

De Benedictis, L, M Gallegati, and M Tamberi (2009), "Overall trade specialization and economic development: Countries diversify", Review of World Economics 145(1): 37–55. 

Cozzi, G and S Galli (2014), "Sequential R&D and blocking patents in the dynamics of growth", Journal of Economic Growth 19(2): 183–219. 

European Commission (2012), "Industrial revolution brings industry back to Europe", press release, 10 October. 

Gersbach, H and M T Schneider (2015), "On the global supply of basic research", Journal of Monetary Economics 75: 123–137. 

Gersbach, H, U Schetter, and S Schmassmann (2019a), "From local to global: A unified theory of public basic research", CEPR discussion paper 13833.

Gersbach, H, U Schetter, and S Schmassmann (2019b), "Taxation, innovation and entrepreneurship", Economic Journal 129(620): 1731–1781.

Hausmann, R and C A Hidalgo (2011), The network structure of economic output", Journal of Economic Growth 16(4): 309–342. 

Hunter, R S, A J Oswald, and B G Charlton (2009), "The elite brain drain", Economic Journal 119(538): F231–F251.

Imbs, J and R Wacziarg (2003), "Stages of diversification", American Economic Review 93(1): 63–86. 

Jaffe, A B (1989), "Real effects of academic research," American Economic Review 79(5): 957–970. 

Jaffe, A B, M Trajtenberg, and R Henderson (1993), Geographic localization of knowledge spillovers as evidenced by patent citations," Quarterly Journal of Economics 108(3): 577–598. 

Keller, W (2002), "Geographic localization of international technology diffusion," American Economic Review 92(1): 120–142. 

Keller, W (2004), "International technology diffusion", Journal of Economic Literature 42(3): 752–782. 

Keller, W and S R Yeaple (2013), "The gravity of knowledge", American Economic Review 103(4): 1414–1444. 

Mazzucato, M (2013), The Entrepreneurial State, Anthem Press.

McKinsey Global Institute (2012), Manufacturing the future: The next era of global growth and innovation

Miguelez, E and C Fink (2013), "Measuring the international mobility of inventors: A new database", World Intellectual Property Organization, Economics and Statistics Division working paper 8.

Nelson, R R (1959), "The simple economics of basic scientific research", Journal of Political Economy 67(3): 297–306. 

Nelson, R R (2004), "The market economy and the scientific commons", Research Policy 33(3): 455–471. 

Parteka, A and M Tamberi (2013), "What determines export diversification in the development process? Empirical assessment", The World Economy 36(6): 807–826. 

Pisano, G P and W C Shih (2012), "Does America really need manufacturing?", Harvard Business Review 90(3): 94–102. 

Ramakrishnan, V (2017), "Pro-science budget is not enough for a Brexit world", Nature 551: 543.

Research Prioritisation Project Steering Group, Ireland (2012), Report of the Research Prioritisation Steering Group

Romer, P M (1987), "Growth based on increasing returns due to specialization," The American Economic Review 77(2): 56–62. 

Romer, P M (1990), "Endogenous technological change", Journal of Political Economy 98(5): S71–S102. 

Schetter, U (2019), "Quality differentiation, comparative advantage, and international specialization across products," SSRN technical report.

Stephan, P (2012), How Economics Shapes Science, Harvard University Press.


Endnotes

[1] This is exemplified by a quote from Annegret Kramp-Karrenbauer, leader of the CDU Germany, who stated at the electoral party convention on the 7th of December 2018: "We will [guarantee that] we make money in Germany out of the products and ideas [from research]. It is nice to do research with taxpayers’ money, but it is even nicer if we make money out of it." (Gersbach et al. 2019a)

[2] A large literature documents various forms of international knowledge spillovers and spatial dependence in the diffusion of knowledge (Jaffe 1989, Jaffe et al. 1993, Keller 2002, Keller 2004, Keller and Yeaple 2013, Bahar et al. 2014).

[3] A hierarchy of R&D activities is also the predominant view in the literature on basic research (Aghion and Howitt 1996, Cozzi and Galli 2014, Gersbach and Schneider 2015, Akcigit et al. 2013).

[4] The idea to optimally target basic research investments to industries or fields of science features prominently in policy debates (European Commission 2012, Research Prioritisation Project Steering Group Ireland 2012).

[5] Hence, our work provides a rationale why industrialised countries tend to invest more in basic research without relying on the ad hoc assumption that they are relatively more efficient at it.

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