INTRODUCTION

Innovative activity is often characterized as involving classical spillovers that lead to market imperfections. Knowledge that is created by the innovative activity of a firm spills over to other firms who benefit from the activities of the innovator. New ideas and knowledge diffuse across firms not just because new products are copied by imitators. Diffusion also occurs as the new ideas of one firm are improved by others and as general knowledge is incorporated into new production processes. The importance of the diffusion of new ideas has been used to justify governmental support for the innovation process.

A second argument used to justify support is that input markets are imperfect for innovative firms. In particular, innovative firms are characterized as having problems in obtaining financing, partly because their assets are ‘soft’ and thus do not offer the same collateral as machinery and equipment, partly because their activities are more risky. As a result, financing is characterized as being unduly costly.

In previous chapters, we have provided information on the general importance of innovation, on patterns of diffusion across sectors, on the nature of interactions across firms, on the importance of R&D, and on problems related to appropriability. This chapter focuses on issues relating to the financing of R&D. It examines three issues.

First, we examine the composition of innovation costs. Government policy is often directed at subsidizing expenditures on R&D, since they are seen as the focal point of the innovation process.