Contribution to the International Encyclopedia of the Social Sciences, second edition.
Bronwyn H. Hall
December 2006

Research and Development
Research and Development (R&D) is the term commonly used to describe the activities
undertaken by firms and other entities such as individual entrepreneurs in order to create new or
improved products and processes. The broadest meaning of the term covers activities from basic
scientific research performed in universities and laboratories all the way to testing and refining
products before commercial sale or use. The performance of, incentives for, and thecontributions of R&D are topics that are widely studied in management, economics, and othersocial science disciplines. Total spending on R&D activities is also one of the most widely usedindicators of the innovative performance of firms, industries, and countries.
Informal R&D has existed at least since the first person experimented with methods ofknapping flint to make stone age tools. In a formalized sense, it became part of the arsenal of themodern corporation beginning with the creation of industrial labs in the late 19th century andtoday it comprises about 2-3 per cent of the GDP in advanced economies (for a history of the riseof organized R&D in the U.S., see the 1989 book by David Mowery and Nathan Rosenberg).
Spending on and outcomes of R&D investments have become important enough to be the subjectof a satellite account in the US System of National Income Accounts that was introduced in
2006-2007 and to be under consideration for inclusion in the international standard for systemsof national income accounts (United Nations 2006).
The Frascati Manual of the Organization for Economic Cooperation and Development(OECD), first published in 1963, created an international standard for surveys of spending onR&D. This manual defines R&D as “creative work undertaken on a systematic basis in order to1

increase the stock of knowledge, including knowledge of man, culture and society, and the use ofthis stock of knowledge to devise new applications.” R&D is generally thought to consist of
three main activities: basic research, applied research, and development. Basic research isresearch undertaken primarily to acquire new knowledge without a view as to its application.
Applied research is research directed towards a specific objective and development is work
drawing on existing research results and directed specifically towards the creation of new andimproved products and processes. In general, more than two-thirds of R&D spending by firms orcountries is directed toward development rather than research. The 2003 OECD Science,Technology, and Industry Scoreboard reports that in developed countries with high R&D
intensities, basic research is less than one fifth of total R&D spending.

Economic analysis of R&D
In the theoretical economics literature, the term “R&D” is commonly used to describe theconscious choice of firms and individuals to invest in the invention and commercialization ofnew products and processes. Although the activity being described is seldom made precise inthese models, in practice this kind of investment is assumed to correspond roughly to thespending on R&D that is reported in firm accounts and to various governmental surveys.
Important insights into the motives underlying investments in R&D were first developed inseminal papers by Richard Nelson in 1959 and Kenneth Arrow in 1962. These two authors
clearly argued the economic policy case for subsidies to R&D investment that arise from thenature of its output.
Briefly stated, the argument is that because most inventions (processes and products) canbe imitated once they are made, and at a cost lower than the original cost of making them, the2incentives for undertaking R&D directed toward the creation of such inventions are inevitably
weaker than society would like. The performance of R&D therefore generates positive
externalities or spillovers that benefit others. The paper by Nelson distinguishes between basic
research with wide applications (which is most likely to be insufficiently provided) anddevelopment expenditures targeted to particular products or processes (which are more easily
protected by patenting and other means). Arrow made the case for underinvestment in R&D
more broadly, by setting it in the context of the (then) newly invented Arrow-Debreu generalequilibrium model. He argued that the allocation of resources for invention (that is, R&Dspending) was likely to be non-optimal because the production of information about newproducts and processes failed all three of the assumptions required for perfect competition toachieve a Pareto optimum: that the good (information) be infinitely divisible, that it be tradableon the market (that is, its returns fully appropriable by the owner), and that there be no associateduncertainty.
All three of these characteristics (indivisibility, inappropriability, and uncertainty) have
proved to be important in the case of R&D. Indivisibility implies returns to scale because
information about new products and processes can be spread over many units at increasingly
lower cost per unit, leading to monopolistic competition in R&D-intensive industries. As Arrowand subsequent economic theorists have shown (see the 1989 survey by Jennifer Reinganum),
this can lead to either over or underinvestment in R&D from a social perspective. In contrast,lack of full appropriability suggests that there will be underinvestment in R&D. In a 1992 article,
Zvi Griliches surveyed the evidence on the existence of R&D spillovers -- based on the evidence
on measured private and social returns to R&D from a wide number of empirical studies, he3

concluded that overall R&D spillovers were both “prevalent and important.” This result suggeststhat underinvestment dominates overinvestment, at least in the majority of sectors.
Finally, uncertainty about the nature of the information to be produced by R&D makes it
a risky undertaking and sometimes implies that there will be an asymmetric information problem
between its producers and those who might finance its production, again leading to potential
underinvestment. Empirical evidence for the existence of difficulties in financing R&D
investment is surveyed by Bronwyn Hall in an article published in 2002.

R&D as investment
The phrase “R&D” is often followed by the word “investment,” which hints at one its
most important attributes: research and development undertaken today continues to benefit boththose who undertake it and society at large into the uncertain future. Another attribute of R&D
that has been emphasized in the modern economic growth literature is its cumulative nature,
which can lead to increasing returns, both in the aggregate, and also for individuals and firms.
The idea is that the stock of knowledge created by doing R&D makes one more productive inacquiring additional knowledge. In the case of individuals, this is sometimes termed the“Matthew” effect (after the Gospel, XXV, 29). In the case of economies, it has given rise to themodern endogenous growth literature that is discussed in the 1998 book by Philippe Aghion andPeter Howitt.
These attributes create some interesting problems for measurement and analysis. Ingeneral, applied researchers have dealt with the intertemporal nature of R&D investment bytreating it in the same way as ordinary investment in tangible assets, adding up expenditures tocreate an R&D stock, using a suitable depreciation rate to capture the fact that older research4may become less useful over time. However, the aforementioned spillover effects make thisexercise somewhat more speculative than in the case of ordinary assets, because R&D that hasceased to be useful for the production of private profit may still be useful to others in theproduction of new knowledge. The process that renders some R&D output obsolescent is thesame one that was given the name “creative destruction” long ago by Joseph Schumpeter (1942).
For a recent survey of the R&D depreciation problem and its implications for measuring thereturns to R&D, see Bronwyn Hall (2006).

Bibliography
Aghion, Philippe and Peter Howitt. 1998. Endogenous Growth Theory. Cambridge, MAand London: MIT Press.
Arrow, Kenneth. 1962. "Economic Welfare and the Allocation of Resources forInvention." In The Rate and Direction of Inventive Activity, edited by Richard R. Nelson, 609625. Princeton, NJ: Princeton University Press.
Bush, Vannevar. 1945. Science: The Endless Frontier. Washington, DC: U.S.
Government Printing Office.
Cohen, Wesley M. and Richard C. Levin. 1989. "Empirical Studies of Innovation andMarket Structure." In The Handbook of Industrial Organization, edited by Richard Schmalenseeand Robert D. Willig, 1059-1107. Amsterdam: North-Holland.
Griliches, Zvi. 1979. "Issues in Assessing the Contribution of R&D to Productivity
Growth." Bell Journal of Economics 10: 92-116.
Griliches, Zvi. 1992. "The Search for R&D Spillovers." Scandinavian Journal ofEconomics 94 (Supplement): S29-S47.

5Hall, Bronwyn H. 2006. “R&D, Productivity and Market Value” Annales d’Economie etde la Statistique, forthcoming. Available at http://www.econ.berkeley.edu/~bhhall/bhpapers.html
Hall, Bronwyn H. 2002. “The Financing of Research and Development.” Oxford Reviewof Economic Policy 18 (1): 35-51.
Mowery, David C. and Nathan Rosenberg. 1989. Technology and the Pursuit ofEconomic Growth. Cambridge: Cambridge University Press.
Nelson, Richard R. 1959. "The Simple Economics of Basic Scientific Research." Journalof Political Economy 77: 297-306.
OECD. 2002. Frascati Manual: Proposed Standard Practice for Surveys on Researchand Experimental Development. Paris, France: OECD.
OECD. 2003. Science, Technology and Industry Scoreboard. Paris, France: OECD.
Reinganum, Jennifer F. 1989. "The timing of innovation: Research, development, anddiffusion." In The Handbook of Industrial Organization, edited by Richard Schmalensee andRobert D. Willig, 850-908. Amsterdam: North-Holland.
Schumpeter, Joseph. 1976 (1942). Capitalism, Socialism and Democracy. New York,NY: Harper and Row.
U.S. Department of Commerce. 2006. R&D Satellite Account, news release of September
28, 2006, at http://bea.gov/bea/newsrel/rdspendnewsrelease.htm
United Nations Statistics Division. 2006. National Accounts: Research and Development,
http://unstats.un.org/unsd/nationalaccount/nadefault.htm

Bronwyn H. Hall
Professor of the Graduate School, University of California at Berkeley
Professor of Technology and the Economy, Maastricht University6