Key Takeaways

Contents

Key Takeaways. 1

Introduction. 2

The Theory of Firm Size and Innovation. 2

The White House Study. 3

Endnotes. 6

Introduction

Small firms are nimble, hungry, innovators. Large corporate giants are sluggish, risk-averse, copiers. Or so goes the conventional wisdom, which the Biden administration’s National Economic Council has recycled in a new report titled “The Economics of Investing in America.”^[1] In a section declaring “To succeed we must ensure fair competition,” the report states: “The evidence is clear that new small and medium-sized businesses are drivers of innovation.” The unsubtle insinuation is that large firms are somehow stifling innovation by small firms and innovating much less. But the studies that the NEC cites do not support this conclusion, nor do most other studies or data. In fact, as the Information Technology and Innovation Foundation (ITIF) has demonstrated repeatedly, it is a myth.[2]

So why advance that narrative? Make no mistake: In the anticorporate Neo-Brandeisian agenda, “fair competition” is code for fewer large corporations. If the White House can advance a narrative that lazy large firms are stifling innovation by small companies, which are the true innovators, then it’s easier to advance its anticorporate antitrust agenda, including banning all mergers and even breaking up large corporations.^[3]

To be sure, a core strength of the U.S. innovation ecosystem is the vibrant role start-ups play in innovation, a role that is enabled by, among other factors, the ability of large firms to acquire innovative start-ups and provide the founders with an exit strategy.^[4] But the narrative that “Big Innovation” inhibits small and mid-sized innovation, and that big firms have “little incentive to better serve customers,” is simply wrong, as most studies and data show. Moreover, the United States requires very large business because America faces intense competition from massive, state-backed corporate giants from China such as Huawei, Alibaba, Tencent, China State Construction Engineering, and Baidu, which together invested $53 billion in R&D in 2021. So, it is imperative that federal innovation policy be guided by objective analysis, not by feel-good myths and anticorporate animus.^[5] We need size-neutral innovation policy.

The Theory of Firm Size and Innovation

Economists have studied the relationship between firm size and innovation for over a century. Joseph A. Schumpeter’s 1911 book, The Theory of Economic Development, focused on the entrepreneur as the driving force for innovation. He wrote, “The typical entrepreneur is more self-centered than other types, because he relies less than they do on tradition and connection and because his characteristic task … consists precisely in breaking up old, and creating new, tradition.”^[6]

But writing thirty years later, after the emergence of dedicated corporate research labs and what Alfred Chandler called the “managerial corporation,” Schumpeter viewed the large corporation as central to innovation. In Capitalism, Socialism, and Democracy, published in 1942 he said, “Technological progress is increasingly becoming the business of teams of trained specialists who turn out what is required and make it work in predictable ways.”^[7] He went on to observe that innovation by individual inventors and entrepreneurs “is already losing importance and is bound to lose it at an accelerating rate. … Innovation itself is being reduced to routine. Technological progress is increasingly becoming the work of trained specialists who turn out what is required to make it work in predictable ways.”^[8] According to Schumpeter, “There cannot be any reasonable doubt that under the conditions of our epoch such superiority is as a matter of fact the outstanding feature of the typical large-scale unit of control.”^[9]

Schumpeter’s argument that firms with temporary monopolies would have both the resources and the incentive to innovate was challenged by the economist Kenneth J. Arrow, who argued that innovation would be greater in more competitive markets.^[10] But as the Council of Economic Advisers reported during the Obama administration, “Allowing firms to exercise the market power they have acquired legitimately can maintain incentives for research and development, new product introduction, productivity gains, and entry into new markets, all of which promote long term economic growth.”^[11]

The White House Study

The study cited by the National Economic Council as evidence of its sweeping insinuation that small companies that are somehow the most important drivers of innovation, neither says that nor even attempt to study this broad question.^[12] Rather, its aims are more modest: to investigate commercialization of university research. The authors conclude that “Start-up ventures are an increasingly important organizational form in the commercialization of university technologies.”^[13] The authors cite data showing that:

There is significant growth in the proportion of start-up licenses granted by the top-25 research universities in our sample, rising from 17% in 2001 to 29% in 2019. This rise in start-up licensing is accompanied by a corresponding decline in the share of licenses to large incumbent firms, which fell from 37% to 26% during the same period.^[14]

So, large and small firms are now close to even when it comes to technology licenses from universities. The authors also find that incumbents, many of which are large, were granted almost twice as many patents as start-ups.^[15] This is hardly evidence that small firms are the key and large firms irrelevant, as the White House report implies.

The authors go on to write, “We observe that while universities and start-ups both generate similar numbers of patents, the majority of inventions in our sample are generated by incumbent firms.”^[16] They note:

our findings of a “start-up advantage” are likely to be driven in part by a selection effect: whether due to private information, credit constraints, or other factors, start-ups tend to pursue a smaller number of high impact innovations, while incumbents develop a larger number of innovations that are, on average lower in terms of forward citations, originality, and generality.^[17]

In short, they find that start-ups do play an important role in one kind of innovation, but large firms do too.

Data and other scholarly research show that large corporations play a leading role in innovation. The top 1.5 percent of patenting firms, all large firms, are responsible for 48 percent of all patents from 1999 to 2008. In 2011, 108,626 utility patents of U.S. origin were granted. Just fifty U.S. companies getting the most patents (all large corporations) were responsible for over 30 percent of these patents. The reality is that only a tiny fraction of the nation’s 6 million small firms patent or innovate.^[18] This is not to say that some small, technology-based firms are not highly innovative. But to assume that small equates with innovative or entrepreneurial is not accurate.

Studies touting the superiority of small firms in innovation thus need to be interpreted with care. First, while small technology companies in some industries may be more innovative dollar-for-dollar than large firms, the real question is the share they contribute to overall innovation. On this measure, it is small. For example, one study found that while small technology firms patent more per employee than large firms, they were responsible for just 6.5 percent of patents from 2002 to 2006.^[19] In other words, while small technology firms may be more efficient at innovation, collectively they do much less of it than large firms. In fact, one firm, IBM, received more patents than all the 504 small firms in the study combined.

When looking at small firms that had received more than 15 patents in five years Nolan and co-authors found that a number of firms fell out of the database. Six percent of small firms became large firms, while 17 percent had merged or been acquired. Most of the remaining small firms that dropped out did so because they fell below the fifteen-patent threshold, while another 4 percent dropped out because they became troubled or declared bankruptcy. Among the top 700 firms in 2003, the top seventeen were responsible for 25 percent of all R&D expenditures, the top thirty-three for 40 percent, and the top 300 for 80 percent.^[20]

The National Science Foundation’s (NSF’s) annual innovation survey found in 2020 that very large companies (over 25,000 workers) are almost four times more likely to introduce a new market innovation than small businesses.^[21] The survey also found that the largest companies were almost five times more likely than small companies to develop a new technology in house as opposed to acquire it from other companies or to marginally modify existing technology.^[22] Small companies were also more than 5 times more likely to abandon a technology project before completion than were large companies.

Moreover, while small firms account for 49 percent of U.S. employment, they account for just 16 percent of business spending on R&D, while firms of more than 25,000 workers account for 36 percent.^[23] Likewise, they account for 18.8 percent of patents issued, while the largest firms account for 37.4 percent of patents.^[24] Average R&D spending per worker increases with company size (not controlling for industry), with firms with 5 to 39 workers spending around $790 per worker and large firms with 5,000 or more workers spending around $3,370 per worker.^[25]

When ITIF surveyed almost 1,000 U.S. scientists and engineers involved in filing triadic patents (patents filed in the United States, Europe, and Japan), they found that approximately 75 percent of materials science and IT patents and 60 percent of life science patents were filed by firms with more than 500 employees.^[26] Countering the popular narrative that large firms are sluggish copiers and small firms the true innovators, firms with 500 or fewer workers in the sample accounted for only around 30 percent of patents, yet they employed 48.4 percent of workers. As the innovation scholar Luc Soete has found, “Inventive activity seems to increase more than proportionately with firm size.”^[27]

Other research suggests that even among firms that patent, the assumption that small firms are more innovative is not that simple, in part because of the focus on patents as a measure of innovation. In a 1996 paper, Wesley M. Cohen and Steven Keppler found that R&D and firm size are closely related. In other words, large firms invest more in R&D as a share of sales.^[28] Like other scholars, Cohen and Keppler found that the number of patents and innovations produced per R&D dollar declined with increasing firm size. But they argue that this is not due to inefficiency, bureaucracy, or lack of drive, but rather reflects a mismeasurement of innovation outputs. Large firms engage in “cost spreading,” in which the benefits from one innovation are spread across more units and products, leading to a greater overall level of innovation per unit of R&D. They write, “Not only does cost spreading provide the basis for explaining the R&D-size relationship, it also challenges the consensus that has emerged from the R&D literature that large firm size imparts no advantage in R&D competition.”^[29] Further, “By applying the fruits of their R&D over a larger level of output, larger firms not only have a greater incentive to undertake R&D than smaller firms but they also realize a greater return from their R&D than smaller firms.”^[30]

In 2016, business professors Anne Marie Knott and Carl Vieregger explained how previous studies got the data wrong.^[31] Historically, innovation scholars have relied on product or patent counts as a proxy for innovation output. But doing so overemphasizes product innovation and underestimates process or incremental innovation—innovation activities that large firms engage in more but rarely involve a patent filing. But the recent development of NSF’s Business Research and Development and Innovation Survey allowed them to better analyze incremental and process innovation. They estimated that a 10 percent increase in the number of employees increases R&D by 7.2 percent and that a 10 percent increase in firm revenues increases R&D productivity by 0.14 percent. Their conclusions show that large firms invest more in R&D activities and enjoy higher returns on innovation output per dollar invested in R&D.

One problem with this debate about whether small firms are more important to innovation is that their role appears to differ by industry. As Giovanni Dosi and co-authors noted, “Innovative firms are likely to be rather small in industrial machinery; big firms prevail in chemicals, metal working, aerospace and electrical equipment, while many ‘science-based’ sectors (such as electronics and pharmaceuticals) tend to display a bimodal distribution with high rates of innovation of small and very large firms.”^[32] Indeed, small firms play a more important role in some industries than in other industries, and at different times. In other words, a healthy innovation ecosystem depends on a mix of firm sizes. As Zoltan J. Acs and David B. Audretsch found in one of the definitive studies on the issue, “The greatest difference between the large- and small-firm innovation rates, implies that the correct answer is: It depends on the particular industry. For example, in the tire industry, the large-firm innovation rate exceeded the small-firm innovation rate by 8.46, or by 8 innovations per 1,000 employees.”^[33] They found that in industries characterized by higher levels of capital intensity, “innovation tends to be greater in large firms than in small firms.”^[34] For example, it cost Boeing over $15 billion to develop the carbon fiber 787 plane.^[35] It now costs around $500 million to develop a leading-edge semiconductor, and $5 billion to build a fab.^[36] It can cost over $2 billion to bring a new drug to market.^[37] It costs over $2 billion to bring a new drug to market. It can cost billions of dollars to develop advanced AI systems.

Other research has found that “small firms prevail in the early stages and innovation tends to concentrate in larger firms as industries evolve towards maturity.”^[38] We saw this in the 1990s when many small firms emerged and competed to be the winners in IT. But only a few firms could emerge as winners, and the ones that did continued to invest in innovation to improve their products and services and gain advantage in related activities. As one study concluded, “The question is no longer whether size positively or negatively affects innovation but under what circumstances may small firms enjoy an innovation advantage over large ones (and vice versa).”^[39] This is why Frederic M. Scherer’s warning that “the search for a firm size uniquely and unambiguously for invention and innovation is misguided” is such good advice.^[40]

This is not to say that tech start-ups and small R&D-intensive firms are not important to driving innovation, but to privilege small over large when it comes to innovation is a fundamental mistake. We need size neutrality when it comes to federal innovation policy, not adulation of start-ups grounded in large-company animus.

Endnotes