Becker Friedman Institute
for Research in Economics
The University of Chicago

Research. Insights. Impact. Advancing the Legacy of Chicago Economics.

Cascading Innovation

March 2017
Vasco M. Carvalho, Mirko Draca

US government spending since World War II has been characterized by large investments in defense-related high-tech goods and services and R&D. In turn, this means that the Department of Defense (DoD) has had a large role in funding corporate innovation in the US. This paper (i) quantifies the impact of military procurement spending on corporate innovation by publicly listed firms and (ii) shows that DoD impact on innovation was not limited to the winners of defense contracts but instead cascaded through the supply chain of DoD contractors via indirect market size effects, working through firm-to-firm input linkages. We use a database of detailed, historical procurement contracts for all Department of Defense (DoD) prime contracts since 1966. Product-level spending shifts are used as a source of exogenous variation in firm-level procurement receipts. We combine this data with information on the supply chain linkages of publicly listed firms. Our estimates indicate that defense prcurement has a positive direct impact on patenting and R&D investment, with an elasticity of approximately 0.07 across both measures of innovation for DoD contractors. Further, our estimates imply that the derived demand for inputs following the award of a DoD contract constitutes a large indirect market size effect for the suppliers of DoD contractors. These indirect market size effects in turn induce innovation cascades working up the supply chain. We find that the elasticity of innovation outcomes to indirect DoD market size shocks is about half of that estimated for direct contractors but affects a much larger number of firms, increasing the effect of defense spending on aggregate innovation by at least 20%.