Production Networks and R&D Allocaition

Abstract

This paper investigates how production networks shape firms’ R&D decisions and the resulting aggregate inefficiencies. We develop a dynamic model in which firms form supplier relationships through an exogenous yet persistent matching process and rely on those links to introduce new products. The model features two sources of misallocation. Market-power distortions and a network-formation externality whereby firms fail to internalize that their R&D makes them more attractive trading partners, improving match quality for all firms in the economy. We estimate the model using Japanese firm-to-firmtransaction and patent data and show that the first-best allocation lies close to the decentralized outcome. Market-power corrections raise R&D incentives for older firms by relieving double marginalization along long supply chains. Internalizing the network-formation externality instead tilts R&D toward younger firms that expand their supplier base most rapidly. These opposing forces offset each other, leaving the planner’s allocation near the observed one.