Basically Trapped -- A General Equilibrium Approach to the Undersupply of Basic Research in Free Markets

TL;DR

This paper introduces a micro-founded general equilibrium model with endogenous research activities, revealing that significant subsidies or state funding are necessary to address the undersupply of basic research in free markets.

Contribution

It develops a novel model distinguishing three research types and proposes a flexible approach to modeling basic research spillovers, highlighting policy implications for basic research funding.

Findings

Basic research is undersupplied in free markets.

Large subsidies are needed to increase basic research.

State financing can approach social planner outcomes.

Abstract

In this paper I propose a micro-based innovation driven general equilibrium growth-model allowing for endogenous entry and exit as well as three different types of research. I make the novel distinction between three types of firms, namely basic and applied research where applied research is again differentiated into high and low type research to account for a heterogeneous firm environment. I further propose a new and flexible way to model basic research spillovers in this model class. While previous literature addresses the effect of R&D policies in general, my findings suggest, there is no optimal market solution in which basic research takes a noteworthy share. In order to counteract this undersupply and to take advantage of basic research spillovers, a sizable basic research subsidy is required to sufficiently crowd-in basic research which then allows for a substantial increase in welfare. My findings also suggest the necessity for purely state-financed basic research to approach the social planner solution in a feasible manner.