Enterprise development
Working paper

Innovation activity in South Africa: Measuring the returns to R&D

by Andre Steenkamp, Mark Schaffer, Wayde Flowerday, and John Gabriel Goddard
March 2018

The only way to effectively increase economic growth in the long term is through improvements in productivity. In the long run, productivity is everything: a country’s ability to improve its standard of living over time depends almost entirely on its ability to raise output per worker (Krugman 1992, cited in Lin and Tang 2013). The literature emphasizes a positive correlation between firm-level innovation and productivity gains, although evidence for developing countries has been less conclusive. It is unsurprising, then, that policy makers and researchers widely acknowledge that investment in innovation is one of the major drivers of productivity growth, and is therefore of critical importance. The major finding in growth accounting literature is based on Robert Solow’s (1957) famous residual, interpreted as the consequence of innovation and improvements in technology. The now-standard explanation is that technological progress is the key contributor to economic growth, whereas increases in the factors of production such as capital and labour are not as important for growth (Kortum 2008). Based on this premise, evidence on the sources of technological change and channels of innovation are important for informing policy that can assist firms to engage more actively in innovation processes. This matters because firms that introduce business and technology innovations can achieve greater productivity through various channels, including: improved operations, new and higher value-added products and services, entry into new markets, and better use of existing capacity and resources. These innovations are then diffused across sectors as competitors copy best practice, which raises the overall productivity of the economy.

According to Lin and Tang (2013), innovation is essential to transition towards higher value-added economic activity and achieve sustained growth; and investment in research and development (R&D) is key to innovation. This paper aims to enhance our understanding of the dynamics of innovation practice and technology absorption in South Africa at the firm level by estimating the returns to R&D expenditure in the manufacturing sector. This research is novel in that it is one of the first papers to measure the returns to R&D using firm-level data in a developing country. This is done by: (1) estimating the intensity of R&D expenditure across South African manufacturing firms; (2) estimating the elasticity of R&D expenditure with respect to output using a production function approach; and (3) combining these two estimates to derive the estimated return to R&D expenditure in the South African manufacturing sector from 2009 to 2014. This kind of analysis has been done many times for Organisation for Economic Co-operation and Development (OECD) countries, but far less frequently for developing countries, due in part to the lack of accessible firm-level data. Therefore our results are novel not just for South Africa but for the development economics literature more broadly. One reason for such interest in this topic is that R&D investment is important for improving the productivity and competitiveness of firms and the macro-economy. R&D can increase productivity by improving the quality or reducing the average production costs of existing goods or simply by widening the spectrum of final goods or intermediate inputs available (Hall et al. 2009). Second, investment in R&D and innovation more broadly is generally expensive and diverts resources away from other areas that may offer better short-run gains or profitability. Any investment in R&D and other innovation activities requires a long-term view of improving productivity for movement closer towards the productivity frontier at both a firm and economy-wide level.

Our empirical strategy for estimating the returns to R&D in South Africa is essentially comparative. We obtain estimates of R&D intensity and elasticity that we can compare to those obtained in previous studies, largely relating to firms in OECD countries. In summary, we find that: (1) R&D intensity, as measured by the R&D expenditure to sales ratio, in South African manufacturing firms is considerably lower than that observed in studies from other countries; (2) the elasticity of 2 output with respect to R&D is within the range observed in previous studies; and (3) as a simple matter of arithmetic, items (1) and (2) imply that the estimated return to R&D in South Africa is high compared to that found in other countries. Intuitively this makes sense, given the low prevalence, persistence, and intensity of R&D expenditure among South African manufacturing firms. These findings are not out of line with international experience, which shows that developing countries generally invest much less in R&D as a share of gross domestic product (GDP) than developed countries. In addition, Schumpeterian economists argue that countries further away from the technological frontier should have higher rates of return, given the strong potential gains from technological catch-up.

The rest of the paper is structured as follows. In Section 2, we draw on the literature discussing the role of technological change and survey studies which estimate the return to R&D. In Section 3, we discuss the data that are used in the analysis and definitions of the main variables. We outline our approach to estimating the return to R&D in Section 4, which is followed by a descriptive summary of the data. Section 6 discusses the intensity of R&D expenditure in South Africa. Results from the econometric analysis are presented and discussed in Section 7, followed by concluding remarks in Section 8.