In a divided world, the mobilization of private resources is crucial for addressing societal needs. Government strategies have a central role to play.
In October 1957, the Soviet Union successfully launched Sputnik 1, the world’s first artificial satellite, from the Baikonur Cosmodrome. The consequences were dramatic. Within months, the US government had created NASA, and the Space Race was well and truly under way.
Today, global division and competition for technological advantage are again converging. As the world focuses on the rapid evolution of technologies, such as artificial intelligence and robotics, the US potentially faces a new Sputnik moment – this time coming from China. The question of whether a democratic society can rely on for-profit firms to address its most pressing technological challenges is once again highly relevant. To answer it, we must understand firms’ incentives to invest in innovation, the role of government in encouraging research and development (R&D), and the types of firms that respond to technological challenges.
Strengths and weaknesses of a specialized innovation system
Over recent decades, American companies have increasingly prioritized maximizing shareholder value over other objectives. According to standard economic theory, this should benefit both the companies themselves and society as a whole by creating a win-win situation. In striving to maximize profits, private firms naturally aim to become more efficient. This is particularly evident in the field of innovation, where a more specialized distribution of innovative tasks has emerged.
A highly specialized innovation system can sometimes work well to solve big societal challenges. A remarkable case in point is the development of the mRNA vaccine for Covid-19. Diverse entities played indispensable roles, underscoring the potential of such a system. Foundational research was conducted by government-funded university researchers, while startups like BioNTech and Moderna made significant contributions to the advancement of the technology. Established pharmaceutical companies, notably Pfizer, took charge of testing, production and distribution. While Pfizer and its partner BioNTech developed their vaccine internally, Moderna benefited from substantial government research and development contracts under Operation Warp Speed.
The division of innovative labor is a fundamental advantage of the American innovation system, yet it comes with significant limitations. These include the potential failures to consider positive externalities associated with linking upstream R&D and downstream production activities (a coordination problem), and to solve problems with high social returns but limited private benefits (an incentive problem). While research conducted in American firms has historically created massive benefits to society, the sponsoring firms often failed to capture the value those projects delivered.
A notable case is Xerox’s Palo Alto Research Center (PARC), which generated limited revenues for its parent company despite starting the graphical user interface (GUI) revolution in computing. (The Alto computer was a commercial failure, but was subsequently benchmarked by Apple and Microsoft to great effect). This was, in part, the result of weak appropriability conditions: that is, the legal, technological and institutional factors that affect how far a firm can retain the added value it creates through innovation, such as intellectual property rights. For example, it was difficult to patent computer software, meaning that spillovers from Xerox’s PARC were mostly externalized to other firms.
The Xerox PARC example underscores a crucial vulnerability in highly specialized innovation ecosystems: firms might hesitate to invest in projects that offer substantial social benefits if they cannot secure adequate private returns due to limited appropriability conditions. This concern is less prominent in innovation ecosystems that comprise large and diversified corporations, which are better equipped to capitalize on investments that yield significant societal value.
Bridging the gap between private and societal goals
Often, firms’ objectives do not align closely with such broader societal goals as addressing climate change or bolstering national defense. This makes the government instrumental in facilitating the mobilization of private resources to meet broader societal needs. By leveraging its scale as a financier of basic research and a buyer of innovative products, the government can bridge the gap between private interests and societal goals, ensuring that resources are directed towards areas of global and national importance.
Throughout history, the US federal government has played a pivotal role as an early investor and a fundamental source of American innovation, primarily through agencies like the Defense Advanced Research Projects Agency (DARPA) and national labs, such as the MIT Radiation Laboratory. DARPA, for example, has contributed not only to the development of military technologies such as precision weapons and stealth aircraft, but also to the development of civilian innovations, such as the Internet, automated voice recognition, language translation, and the global positioning system (GPS).
To bridge the gap between private and social returns to R&D investments, the government implements innovation policies that can be classified into two main categories: push and pull. Push policies entail providing financial support for R&D inputs through research grants, while pull policies largely involve the government procuring outputs – innovative products – with the intention of stimulating, or crowding-in, private R&D investments.
In 2021, the federal government allocated $179.5 billion for R&D, but it spent over three times that amount – $593 billion – on purchasing products and services (excluding R&D services). At times, push and pull policies are employed in conjunction with each other, such as when downstream procurement contracts are promised to firms that successfully complete R&D contracts. It is an approach that has been used by NASA recently to incentivize innovation for a Human Landing System (HLS) to take astronauts to the lunar surface as part of the Artemis program. In 2019, NASA awarded three R&D contracts totaling $1 billion to Blue Origin, Dynetics and SpaceX to initiate development of the HLS. In 2021, NASA awarded a single $2.9 billion follow-on R&D contract to SpaceX to continue the project. Blue Origin subsequently offered to invest up to $2 billion in company-funded R&D, in a bid to remain competitive for providing future space transportation services to the government. The example illustrates the power of future government demand as an incentive for companies to invest in R&D, and the importance of pull policies for channeling private resources toward solving society’s challenges.
Prioritizing technological or economic benefits
When making strategic choices on project funding and innovation-intensive product procurement, the government pursues dual objectives: securing technological superiority over rival nations and promoting social and economic development. These objectives are interconnected but have distinct outcomes. Technological leadership is essential for national defense, but does not necessarily guarantee economic benefits and global competitiveness; higher levels of economic development may not generate the advanced technologies required for national defense and geopolitical influence. The government’s emphasis on each objective evolves over time in response to shifting geopolitical realities.
The Sputnik shock serves as a landmark example. During that period, the objective of ensuring technological superiority at any cost took center stage. In more recent periods, economic considerations have taken precedence. This was evident at the end of the Cold War, when the so-called peace dividend allowed issues of national competitiveness, especially in comparison to Japan in critical industrial sectors like semiconductors, to play a prominent role in US policy-making.
The government prioritized cost reduction, increased efficiency and transparency in procurement, the development of dual-use technologies, acquisition of commercial-off-the-shelf products, and the use of ‘full and open competition’ in procurement processes. Today, geopolitical tensions between the US and China suggest that the pendulum might be swinging back toward prioritizing technological superiority.
Yet government cannot solve society’s technological challenges alone. It has to find ways to crowd-in the resources and ingenuity of the private sector, especially because the American innovation ecosystem is heavily reliant on private investment. Data collected by the National Science Foundation show that the ratio of federal funding for R&D to business funding for R&D was 2:1 in the 1950s, but barely 1:4 in 2019. If companies indeed prioritize shareholder value above all else, what does the government need to do to crowd-in private resources to address specific societal needs? And what type of firms and what types of shareholders would be willing to engage with the government in pursuing its dual objectives?
How government can crowd-in private resources
In ongoing research with Larisa Cioaca and Elia Ferracuti from Duke University, we attempt to answer these questions. We explore how the government can effectively attract private resources to address societal needs, such as national defense, and identify the types of firms and shareholders willing to collaborate on achieving these objectives.
Businesses that possess strategic alignment with government objectives, especially those specializing in defense technologies or related sectors, are ideal candidates for collaboration, as they have a vested interest in pursuing government contracts and partnerships that offer growth opportunities and long-term stability. Certain types of shareholders also play a critical role in determining firms’ willingness to engage with the government: those who prioritize long-term value creation and recognize the significance of national defense for societal well-being are more likely to support participation in government initiatives. They include some types of institutional investors, socially responsible investment funds, and wealthy individuals with interests in industries closely connected to national defense.
In our research, we estimate the private value associated with engaging with the government on national defense. We utilize the concept that stock prices reflect the market’s expectations regarding a company’s future profitability: if winning R&D contracts leads to a positive market response, it indicates that shareholders expect to be compensated by the government in the future, through lucrative follow-on downstream contracts. Consequently, companies would be motivated to allocate more of their own resources to pursue the government’s technological objectives, as was the case for Blue Origin.
Our analysis includes 198 US publicly traded firms that receive publicly reportable R&D contracts from the US Department of Defense between April 1984 and September 2015. The sample includes 12,664 firm-award dates. On a typical award date, a firm receives two R&D contracts (at least one from the DOD) and three downstream procurement contracts. The typical revenue from these contracts is $139 million, including $43 million in R&D contracts and $96 million in downstream procurement contracts, while its total potential revenue (including any options the government could exercise in the future) is a larger $168 million.
The private returns associated with these R&D contracts are remarkably high, averaging 19 times the total potential revenue from the R&D contracts. These returns are heavily concentrated in the tails of the distribution. At the 5th percentile of the distribution, the economic value represents a mere 13% of the total potential revenue, while at the 95th percentile, it skyrockets to an astonishing 7,951%. These results indicate that the market expects substantial private value to emerge from engaging with the government on national defense, but only for a select few firms. Two important questions emerge. First, what are the characteristics of these particular firms? This will shed light on the resources that the private sector is likely to mobilize to address technological challenges related to national defense. Second, to what extent does the market expect private value from engaging on other pressing societal challenges, such as climate change?
As anticipated, the estimated private value of engaging with the government on national defense varies by industry and firm type. At the 95th percentile of their respective distribution, the economic value is 30 times for those in consumer industries, for example, compared with 57 times for high-tech industries and 87 times for manufacturing industries. Firms that primarily serve civilian markets get lower private value from DOD R&D contracts compared to defense contractors. In short, firms that are strategically aligned with national defense interests benefit more from government investments in R&D for national defense.
In a landscape dominated by the pursuit of maximizing shareholder value, the government’s role becomes crucial in creating the necessary incentives to mobilize private resources to address societal needs, such as national defense and climate change. By gaining a clear understanding of the types of firms and shareholders willing to engage, and by implementing appropriate strategies, the government can effectively encourage private participation in achieving its objectives. Conversely, firms stand to benefit significantly through strategies that align company goals with the societal goals that are embedded in government’s push and pull policies. Through collaborative efforts, a harmonious alignment of corporate interests and societal welfare can be fostered, leading to mutual benefits for both the private sector and the well-being of the nation.
Sharon Belenzon is Fundación Damm distinguished professor of business administration at the Fuqua School of Business, Duke University.