Guaranteed Markets and Corporate Scientific Research

The U.S. government incentivizes firms to develop innovative technologies by awarding R&D contracts that often carry an implicit promise of “guaranteed demand.” Firms that demonstrate strong technological capabilities are rewarded with noncompetitive production contracts for the resulting products and services. Using newly assembled data on $4.2 trillion in government procurement contracts from all federal agencies, matched to U.S. publicly traded firms, we document a “crowding-in” effect, where government R&D contracts lead to increased investment in corporate scientific research. Firms co-invest with the government at the R&D stage to enhance their chances of securing these lucrative production contracts. We develop a theoretical framework to explain when it is optimal for the government to bundle R&D and production contracts. Our analysis shows that guaranteed demand can produce higher quality at a lower total cost for upstream R&D projects when the R&D firms have production capabilities. Our empirical results confirm these predictions. Additionally, we find that the crowding-in effect has weakened over time as the government has increasingly separated R&D contracts from production contracts. We discuss the potential implications of this decoupling.