Stronger Patent Law Increases the Allocation of Resources to External Relative to Internal R&D: Empirical Evidence


How should a technology firm adjust resource allocation between external and internal R&D in response to stronger patent protection? External R&D provides the firm with another channel of earnings to mitigate diminishing returns to internal R&D, but yields the firm only a fraction of the additional profit generated. Theoretically, if the marginal return to external R&D diminishes more slowly than the marginal return to internal R&D, the firm should increase external R&D more than internal R&D. Exploiting regional differences in the strengthening of patent protection due to the U.S. Court of Appeals for the Federal Circuit (CAFC), we find that the CAFC was associated with 35 percent more external R&D vis-a-vis 20 percent more internal R&D. The difference was more pronounced in industries where patents were less effective in the appropriability of product inventions and among firms more specialized in technology.