University‐firm competition in basic research and university funding policy

• Date: 01 August 2020
• Author: Rune Stenbacka,Mihkel Tombak
• Published date: 01 August 2020
• DOI: http://doi.org/10.1111/jpet.12434

J Public Econ Theory. 2020;22:1017–1040. wileyonlinelibrary.com/journal/jpet

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1017

Received: 18 July 2019

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Accepted: 22 February 2020

DOI: 10.1111/jpet.12434

ORIGINAL ARTICLE

University‐firm competition in basic research

and university funding policy

Rune Stenbacka

1

|Mihkel Tombak

2

1

Department of Economics, Hanken School

of Economics, Helsinki, Finland

2

Department of Management, University of

Toronto, Toronto, Ontario, Canada

Correspondence

Rune Stenbacka, Department of

Economics, Hanken School of Economics,

P.O. Box 479, 00101 Helsinki, Finland.

Email: Rune.Stenbacka@hanken.fi

Abstract

We characterize equilibrium investments in basic

research by the commercial and university sectors

contingent on public funding of the university. We

find that firms invest in basic research despite the

opportunities for free riding and we present condi-

tions under which firms even have incentives to

augment the public funding to the university. We

characterize the socially optimal volume of public

funding for the university sector. Finally, we compare

total investments in a mixed duopoly with those of

duopolies composed of two universities as well as two

profit‐maximizing firms.

1|INTRODUCTION

It has been estimated that developed countries spend approximately 20% of their R&D investments on

basic research (Gersbach, Schneider, & Schneller, 2013). According to a traditional view, basic

research is more important for productivity growth than other types of R&D (shown by, e.g.,

Griliches, 1986). An influential stream of research has therefore, emphasized the structural need for

public policies to support investments in basic research. Classical studies such as Nelson (1959)and

Arrow (1962) establish how features such as appropriability problems, uncertainty and long delays

associated with basic research lead to underinvestments in basic research, thereby justifying a central

role for the government to promote such investments. Stephan (1996) provides an extensive survey of

the literature on the topic of how competitive markets provide poor incentives for the production of

knowledge as this could be a public good that cannot be appropriated. As Rosenberg (1990)in-

sightfully discusses, the possibility of free‐riding on scientific knowledge created by other parties raises

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This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial License, which permits use,

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© 2020 The Authors. Journal of Public Economic Theory published by Wiley Periodicals, Inc.

the question: Why do commercial firms invest in basic research at all? This question attracts attention

to the interaction between the public and private for‐profit, investments in basic research.

In this study, we revisit the question of how to characterize the socially optimal volume of

public funding for basic research. The novel feature is that our characterization relies on the

strategic interaction between the university sector, operating subject to the principle of scien-

tific commons, and the commercial sector able to enjoy the knowledge spillovers from the

university sector. We examine basic research in its role as knowledge serving as an input for

subsequent development activities. Formally, we design an analytical model capturing the

interaction between the university sector, funded by the government (and possibly via dona-

tions or licensing revenues from the commercial sector), and the commercial sector operating

with the objective of profit maximization.

1

In the public sector we take into account that the

decisions regarding investments are made by universities operating with funding acquired from

the government. Further, we also take into account that raising public funds to finance research

by the university sector tends to cause costly distortions to the economy.

We initially present the equilibrium investments by the commercial and university sectors

in a mixed duopoly contingent on the public funding of the university. In particular, we find

that the commercial sector invests in basic research despite the opportunities for free riding and

despite the fact that we do not explicitly account for the role of basic research as facilitating

subsequent development activities (analyzed in Cohen & Levinthal, 1989). Further, we establish

that the firm has an incentive to augment the university's public funding with a donation if the

firm's profit motive exceeds the public funding to the university.

Next, we characterize the socially optimal volume of the funding to the university sector and

we focus, in particular, on how this depends on the following factors: the commercial profit

motive for basic research, the social value of the innovation and the costs of research. Interest-

ingly, the socially optimal volume of public university funding exceeds (falls short of) the profit

motive when this profit motive is sufficiently weak (strong). We compare the totalinvestment in a

mixed duopoly with a public university competing against a for‐profit firm with that of a duopoly

composed of two universities. We find that the socially optimal funding to a sector with two

universities exceeds the socially optimal funding to a mixed duopoly. Further, we show that the

total investment in the presence of optimal funding policy under university duopoly exceeds that

under mixed duopoly unless the profit is very close to total welfare, that is unless consumer

surplus associated with the innovation is very small.Finally, we compare the total investment in a

mixed duopoly with that of a duopoly with two profit‐maximizing firms. In that respect we find

that the investment in basic research with a mixed duopoly cannot exceed that with a for‐profit

duopoly unless the public funding to the university exceeds the private profit motive.

De Fraja (2016) has earlier characterized optimal public funding for research from two different

perspectives: How should research resources be allocated among different institutions differentiated

by their reputation and capacity given that these institutions have informational advantages relative to

the policymaker? And, how should funding of basic research be balanced against funding of applied

research? Ottaviani (2019) examines alternative allocation mechanisms for research funding across

different fields of study. Gersbach, Schetter, and Schneider (2015) address the question of how much

to invest in basic research from the perspective of long‐term economic growth. In contrast to these

studies we characterize the volume of optimal public funding of basic research with a perspective

focusing on research competition between the university sector and the commercial sector. Within

1

We apply a conventional model of R&D competition that can be viewed as a static representation of the classical

models of R&D races (e.g., the single stage game in Harris & Vickers, 1987).

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