A new study by experts from Wharton and the University of Maryland looked at how companies fund projects. They found that between 1975 and 2018, established projects tended to get more money than new ideas. Using a special model, they explained why this happens, shedding light on how companies decide where to invest their resources.
“Financial markets tend to fund the implementation of existing ideas or investment-intensive projects but often fail to adequately fund the discovery of new ideas,” the researchers explain.
The need for fresh ideas
The paper highlighted that economic growth relies on new ideas driving technological progress in the long term. It pointed out that while new companies often bring these ideas, existing ones also contribute significantly. However, existing firms face a dilemma: whether to expand production with what they know works or take a risk on new ideas. This decision is influenced by financial constraints shaped by factors like internal resources and challenges in raising funds.
Firms navigate this dilemma by weighing the benefits of investing in proven projects against the potential of innovative ideas, considering their financial limitations. The paper focuses on financial hurdles, such as limits on borrowing against assets, which affect firms’ choices. Other obstacles include bank lending rules, the trustworthiness of a firm’s management, and biases against certain industries or company types.
The study looked at how these financial challenges affect investment and innovation at both individual firms and in the wider economy. It analyzed spending on physical assets like machinery and buildings, as well as on research and development and patenting activity, to gauge innovation levels.
To cope with financial obstacles, firms often rely on their own resources. The paper measures this by using a firm’s net worth as an indicator of internal resources.
“Firms with low net worth are more likely to be affected by financial frictions, as they need to borrow more to finance their investments than firms with higher net worth,” the researchers say.
Patterns of growth
The researchers noticed a clear pattern in how these firms grow. When they start out small and aren’t worth much, they tend to invest heavily. But as they get bigger and wealthier, they shift gears towards focusing more on innovation. Their model backs up these findings.
Besides looking at how financial obstacles affect individual companies, the authors also looked at the bigger picture – how it impacts the whole economy. According to their calculations, if these financial obstacles weren’t there, the economy would grow about 0.4% faster each year. So, if the GDP usually grows by 2% each year, without these obstacles, it could grow by around 2.4%.
“That’s because more firms are innovating, more new ideas are being discovered, and more new technologies are emerging. Ultimately, that’s what drives long-term growth,” the authors explain. “If you accumulate 2% growth versus 2.4% growth over 20, 30, or 40 years, those are significant differences in terms of GDP.”
While the paper refrains from prescribing particular policy measures, the authors hint that easing financial hurdles could ignite innovation. Policymakers might facilitate this by either subsidizing innovation expenses or lowering the financial burdens on firms, thereby fostering an environment conducive to innovation.
