The Effect of R&D on Quality, Productivity, and Welfare

In this paper we provide a methodology that jointly studies production and demand for multi-product firms using detailed firm-product level data from Denmark. We estimate marginal cost by combining production function estimation with a cost function that allows for quasi-fixed inputs. We use a discrete choice demand model that extends insights from Berry, Levinsohn and Pakes (1995) to obtain a measure of the demand shock (quality). We estimate the relationship between product (process) R&D and quality (efficiency), and find strong evidence that process innovation is related to higher efficiency, while product innovation is associated with higher product quality. We discuss the welfare implications of these two distinct innovation activities.