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 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. This paper is an effort to resolve that puzzle. We propose and test two alternative resolutions: 1) that the puzzle arises from mismeasurement of R&D productivity; and 2) that firm size endogenously drives R&D strategy, and that the returns to R&D strategies depend on scale. We were unable to resolve the puzzle with the second tack: while firm size affects R&D strategy in the manners expected by theory, there was no strategy whose returns decreased in scale. We were however able to reconcile the puzzle under the first tack. Using a fairly recent measure which matches the returns to R&D construct in the firm size theories, we found that both R&D spending and R&D productivity increase with size. Taken together, these results offer a reconciliation of the firm size innovation puzzle—large firms are indeed acting rationally in their increasing R&D investments, as one would expect.