Allocative Efficiency and the Returns to Innovation

Abstract

When producers in a network compete in quantities, an innovator's profit contains none of the change in allocative efficiency that its innovation causes, whether a gain or a loss, because its own choices are optimal and other effects on its profit are transfers. A process innovator also forgoes its own and downstream markups on the output its innovation adds at a fixed allocation, worth 14 to 26 percent of its cost saving for U.S. public firms in 2015. For innovators accounting for 68 percent of sales, the change in allocative efficiency exceeds a tenth of the private return. In a Markov R&D game, reallocation of R&D across firms is likewise external to the innovator. Rivals' profits and market values can misstate the welfare cost of business stealing from them even in sign. With estimated spillovers, the social return to R&D is 5.39 times the private return, against 2.53 in output-based accounting with estimated business stealing, mainly because that accounting credits the innovator with its rivals' lost sales.