R&D Investment in the Knowledge Economy

Last year’s Nobel Prize in Economics went to Paul Romer of the NYU Stern School of Business for “integrating technological innovations into long-run macroeconomic analysis”. The endogenous growth theory, for which he is best known, holds that investment in innovation, as well as human capital and knowledge, are significant contributors to economic growth. Given the integral role of research and development in innovation, the importance of R&D investment is understood.

Yet in many arenas, as noted by researchers Vijay Govindarajan of Dartmouth’s Tuck School of Business, Columbia Business School’s Shivaram Rajgopal, and Anup Srivastava and Luminita Enache of Haskayne School of Business, University of Calgary, R&D continues to be viewed as a discretionary expense. This classifies it as a cost that is separate from operations, and therefore expendable in terms of revenue impact.

The researchers dispute this notion, particularly with regard to technology firms. Their research found that “digital companies’ R&D costs are necessary operating expenses whose curtailment might stop the companies’ operations.” In a knowledge economy, they conclude, ideas, strategies, software, algorithms and innovation become the very foundations of economic activity.

For a digital platform, revenues depend on user engagement, which is fuelled by continuous innovation. The researchers surveyed the financial disclosures of Facebook, Alphabet, Twitter, LinkedIn, Spotify, Netflix and Yelp for fiscal years 2013 through 2017 to determine how R&D affects their user networks and engagement. In an article for Harvard Business Review, the collaborators share insights from this investigation.

First among these insights is that R&D is an “economically significant expense” for digital companies, much larger than for companies that make physical products. For example, in 2017 established digital companies such as Facebook and Alphabet spent 19% and 15% of their sales, respectively, on R&D. Smaller firms might spend as much as 50% or more: In 2013, Twitter spent 76% of its revenues on R&D.

A large portion of R&D costs for digital companies goes to talent, particularly engineering, product management and IT personnel. “Given the global quest for scientific talent and manpower, it is unlikely that digital companies would fire those employees in the short term with the hope of rehiring them in future.” On the contrary, talent is an essential long-term investment, around which digital companies plan their activities. Talent, or lack thereof, can constrain their growth more than anything else. They have no shortage of financial capital; rather human capital, and the knowledge and ideas that come with it, is what their operations depend on.

Not only must digital companies strive continually to engage users, but they must also continually address issues such as cybersecurity, the hyper-competitiveness of their industry, among many others. Technological challenges and market demands make innovation a matter of survival – putting investment in R&D, talent and innovation at the core of operations.