Reconciling the Firm Size and Innovation Puzzle

Abstract

There is a prevailing view in both the academic literature and the popular press that firms need to behave more entrepreneurially. This view is reinforced by a stylized fact in the innovation literature that research and development (R&D) productivity decreases with size. A second stylized fact in the innovation literature is that R&D investment increases with size. Taken together, these stylized facts create a puzzle of seemingly irrational behavior by large firms—they are increasing spending despite decreasing returns. There have been a number of proposals to resolve the puzzle. However, to date none of these proposals has been fully validated, so the puzzle remains. Accordingly, this paper empirically tests the proposals to see whether any resolves the puzzle. We found one proposal (use of alternative measures) was able to resolve the puzzle. When using a recent measure of firms’ R&D productivity, RQ, we found that both R&D spending and R&D productivity increase with firm size. Thus, large firms seem to be acting rationally in their increasing R&D investments, as one would expect.

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