Are growing companies better off acting on new, innovative ideas — or scaling their existing ones? In “Capital, Ideas, and the Costs of Financial Frictions,” Professor Thomas Winberry explores how firms balance investment in current operations with the pursuit of future innovations. This paper earned the 2024 Marshall Blume Prize in Financial Research, awarded by the Rodney L. White Center for Financial Research, and is part of the Jacobs Levy Equity Management Center for Quantitative Financial Research’s series on SSRN.
This study shows that financial constraints can delay a company’s shift toward innovation, and that these delays have significant consequences for long-run growth. In the following conversation, Professor Winberry explains what drives this “pecking order” of firm growth and why improving access to capital could lead to more new ideas, faster progress, and a stronger economy.
Your paper explores how firms decide between investing in existing operations and developing entirely new innovations. What motivated you and your co-author to study this tradeoff, and why is it important for understanding long-term economic growth?
Thomas Winberry: Over the long term, growth is the most powerful driver of economic well-being. In the U.S., GDP per person has grown, on average, around 2% per year over the last 100-plus years. That seems like a small number, but it means huge differences in standards of living: in 1900, average income per person was $5,000 per year (in today’s dollars!) and is now 13 times higher at $65,000 per year.
Economists think that the ultimate source of long-term growth is new ideas which generate technological progress. While we often think of startups as the main source of these ideas, many new ideas actually come from established firms, like Apple with the iPhone. Pablo Ottonello and I were interested in these established firms because they face an interesting joint decision; because they already have some ideas in place, they must decide how much they want to innovate – creating new ideas – and how much they want to invest in capital – scaling up production of their existing ideas.
You introduce a “pecking order of firm growth,” where companies tend to invest first and innovate later. Can you expand on this?
Thomas Winberry: The pecking order refers to a pattern we found in the data. Small firms tend to be “investment-intensive” in the sense that their physical investment rates – accumulating plants, property, and equipment for production – are high, but their innovation rates – research and development and patenting to create new ideas – are low. As firms grow, their physical investment rates fall and their innovation rates rise, transitioning to becoming “innovation intensive.” In other words, small firms grow primarily by scaling up production of their existing ideas, while large firms grow by creating new ideas.
What are financial frictions in this context, and why might they slow a firm’s ability to shift from investment to innovation?
Thomas Winberry: “Financial frictions” are a catch-all for the many obstacles firms have to raising funds from outside investors. In this context, it means that small firms, who don’t have a lot of internal funds themselves, cannot afford to simultaneously do all the physical investment and innovation that they would ideally like to do. Such firms prioritize investment because each dollar the firm puts into capital not only generates a high return on investment but also serves as valuable collateral, allowing the firm to raise more external funding. As the firm grows, the return on investment diminishes and the firm doesn’t need collateral as much, so it pivots toward innovation. The speed at which firms make this pivot critically depends on the degree of financial frictions; in a perfect frictionless world, firms would be able to immediately invest to their optimal scale and become innovation-intensive right away.
How should your findings shape the way investors, firms, and/or policymakers think about financial frictions and innovation?
Thomas Winberry: Our main punchline is that the economic costs from financial frictions are large because they reduce the amount of new ideas in the economy. Quantitatively, we find that our observed 2% growth rate in the U.S. would be higher – 2.4% – in that perfect, frictionless world. Again, that seems small, but when you cumulate it over long horizons it represents massive differences in standards of living. In contrast, the costs from capital misallocation – the fact that firms can’t immediately scale up their existing ideas – are more modest. In other words, financial markets in the U.S. effectively fund the implementation of existing ideas, but don’t adequately fund the discovery of new ideas.
This raises two issues for policymakers. The first one is boring: if we can reduce frictions in financial markets, that would boost long-run growth. But if it were as simple as “reducing frictions,” then it would have already been done – or, at least, there must be powerful reasons why it hasn’t been done. So the second issue is more interesting: given that financial frictions exist, should policymakers intervene in the market? The answer is “yes” if you think that innovation has positive externalities (for example, because an idea produced by one firm can be used by other firms). What’s interesting in our context is that, to achieve this goal, policymakers would actually want to decrease capital investment for constrained firms in order to free up funds for higher innovation, while at the same time they would like to increase investment for unconstrained firms. Simple policies like uniform R&D subsidies or investment tax credits can’t perfectly implement this complicated goal.
How can future research build upon your findings?
Thomas Winberry: The model we developed was designed to be as simple as possible to focus on pecking order, so we hope it’s easy for other researchers to build on. One interesting area is the labor market: if successful innovations by unconstrained firms make workers more productive, that would drive up wages and make innovation even more expensive for constrained firms. Another interesting area to explore would be to incorporate a “market for ideas” where firms can adopt technologies from other firms. But these are just two of our own ideas; the best ones will probably come from someone else!
“Capital, Ideas, and the Costs of Financial Frictions” is a working paper by Thomas Winberry, assistant professor of finance at Wharton and Pablo Ottonello, associate professor at the University of Maryland.
Learn more about Professor Thomas Winberry.
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