Optimal research and development expenditure : a general equilibrium approach

How much should be spent in research and development (R&D)? How should R&D vary over the business cycle? In this paper we answer both questions in the context of a calibrated dynamic general equilibrium model with Schumpeterian endogenous growth. Firstly, we demonstrate that, although the existence of distortions in a decentralized economy produces underinvestment in R&D, a simple proportional subsidy to R&D spending alone cannot restore the first best allocation. The optimal proportional R&D subsidy attains a second best allocation in which R&D spending exceeds its first best level. Secondly, we show how the observed procyclicality of R&D is socially inefficient. However, the welfare loss due to this dynamic inefficiency is much smaller than the loss due to underinvestment in R&D