R&D and the market for acquisitions

We provide a model and empirical tests showing how an active acquisition market positively affects firm incentives to innovate and conduct R&D. Our model shows how the incentives of small firms to conduct R&D in order to innovate increase with competition, demand and the probability that they are taken over. In contrast, we show that large firms optimally may decide to purchase smaller innovative firms and conduct less R&D themselves. Empirically, we document that the R&D of small firms responds more than the R&D of larger firms to demand shocks and the probability of being an acquisition target. The results also show that firm R&D increases with product-market competition and with industry acquisition liquidity and that these effects are stronger for smaller firms. Acquisitions, Research and Developement, Innovation, Competition