R&D/Returns Causality: Absorptive Capacity or Organizational IQ

Abstract

Absorptive capacity is the principle that assimilating new knowledge requires prior knowledge. The attendant prescription is to invest more in R&D to derive greater benefit from the R&D of others (spillovers). Empirical tests of R&D productivity typically find absorptive capacity (R&D * rival R&D) to be significant. This result poses a puzzle, however: What can a firm conducting 50% of industry R&D learn from a set of firms each conducting 5%? Aren't the laggard firms merely playing catch-up? Yet, if this is so, why is the interaction term significant? One possible resolution to this puzzle is that the correlation between R&D spending and returns is really about innate ability (IQ) rather than investment behavior (absorptive capacity). In this view the causality between capability and behavior is reversed. It is not that firms obtain higher returns by investing more in R&D; it is that some firms have higher returns to R&D, thus they invest more. I conduct an empirical test of the competing views and find that (1) firms differ in the output elasticities of their own R&D (IQ) as well as the elasticities of spillovers from rivals, (2) absorptive capacity becomes insignificant when accounting for that heterogeneity, (3) R&D investment increases with IQ, but (4) R&D investment has no impact on a firm's ability to benefit from spillovers.