# _3.2.2. Demand_

A similar argument could be made in relation to market demand. There is a long tradition in innovation studies highlighting the role of demand in pulling technological progress, often based on Kaldor’s ideas about the importance of demand in encouraging investment and the virtuous aspects of high income demand elasticities affecting rates of returns in investing in certain sectors (Dixon and Thirlwall 1975, Kaldor 1966, McCombie and Thirlwall 1995, Schmookler 1962). Demand-pull factors have since been considered key aspects of guiding investment in innovation and explaining heterogeneity in return rates. In turn, lack of demand or uncertainty about future demand are considered deterrents to firms’ decisions to innovate (see, for example, García-Quevedo, Pellegrino, and Savona (2016)).

# _3.2.3. Uncertainty_

The issue of economic uncertainty in general requires specific consideration as a condition that could affect market and learning opportunities and therefore firms’ attainment and appropriation of innovation rewards. A large array of studies analyzes the negative impact of uncertainty on investment due to the existence of irreversibility.<sup>11</sup> A firm has more flexibility to decide between inputs, technologies, and organizational set-ups before it makes the decision to invest in a particular machinery or to initiate a specific R&D project. Then, if relevant variables (such as interest rates, asset prices, exchange rates, input prices, and labor costs) are uncertain, the firm might decide to postpone or cancel its investment decisions, either because it cannot foresee future returns on those investment projects in such an uncertain context or because the expected rate of return that compensates for the increased risk is unachievable. The acquisition of knowledge is not automatic, and learning requires foresight over the medium term. Thus, when a context is highly uncertain and macroeconomic changes cannot be fully anticipated, investment behavior will be limited and contemporaneous rewards on past investments will be reduced, which justifies our consideration of uncertainty as a _market complementary factor_ .<sup>12</sup>

# _3.2.4. Regulations and Business Environment_

Several policy regimes, such as labor, tax, trade, foreign direct investment, and/or competition policy, affect knowledge investment decisions and their impact. For example, the ability to hire engineers and move across tasks in the plant, import machinery, or hire foreign managers affect the effectiveness of R&D. More generally, the regulatory and business environment affects the incentives to invest in innovation activities and the returns to these investments in general. This therefore also makes it an important _market complementary_ factor.

> 11  The papers by Caballero and Pindyck (1996) and Pindyck and Solimano (1993) show that the threshold of the marginal return on capital that triggers investment increases with the volatility of the marginal return, and therefore investment decreases with volatility. Caballero and Pindyck focus on US manufacturing industries, while Pindyck and Solimano’s contribution is a cross-country study. Indeed, they find that the impact is larger for developing countries (see Pindyck and Solimano (1993): 33).

> 12 Given that a less uncertain environment also favors learning, as discussed,  innovative capacity  could also be considered a knowledge complementary factor.

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