Schumpeter and Galbraith hypothesized that larger firms experience lower costs and greater returns from R&D and as a consequence would be expected to perform a disproportionate share of innovative activity relative to their size. Numerous studies of the relationship between firm size and R&D effort have been conducted. The findings are that within the modal industry, above a modest size threshold, R&D effort does not rise proportionally with firm size. Having apparently failed to support the Schumpeterian hypothesis, however, these stylized facts have been largely ignored. Initially assuming that firms exploit their innovations through their own sales and that growth due to innovation is conditioned by current output, this project uses a simple model to explain these stylized facts. The model is then used to explain observed departures from the modal relationships as well. The objective is to explain how industry factors - particularly dynamic factors and appropriability mechanisms within industries -- condition the relationship between firm size and R&D. Using data from the Federal Trade Commission's Line of Business Program, patent data compiled from Scherer and data from the Levin et al. survey on technological opportunity and appropriability conditions in U.S. manufacturing industries, the model is tested to see if the correctly postulated factors that condition the relationship have been specified. The model used in the project provides a distinctive interpretation of the proportional relationship betweeen R&D effort and firm size among R&D performers. In the past, proportionality has been widely interpreted to indicate that there are no particular advantages or disadvantages of size in R&D. In this model, however, the proportional relationship reflects the link between the expected returns from R&D and the firm's ex ante output. It suggests that larger firms will earn greater returns from any given R&D effort than smaller firms, implying an advantage of size and R&D. Thus, the stylized fact that led to the rejection of the Schumpeterian hypothesis, namely the proportional relationship between R&D effort and firm size, may actually reveal an advantage of size. An important implication of the argument is that the returns to innovation are an increasing function of firm size, implying an advantage to firm size in R&D.
