The role of new firms in the information technology industries has rekindled interest in the relationship between firm characteristics and innovation. Are small businesses more innovative in general? Are high-technology start-ups particularly important? If the answer to either of these questions is yes, how should policymakers seek to encourage these firms?
The relationship between innovation and firm characteristics has been one of the most researched topics in the empirical industrial organization literature. To summarize these discussions and draw some implications for policymakers in a few pages is thus a daunting challenge! Consequently, this essay takes a quite selective approach to these issues. First, I very briefly summarize the academic literature on the relationship between firm size and innovation. This work suggests that there appears to be a very weak relationship between firm size, the tendency to undertake R&D, and the effectiveness of research spending. Small businesses, in aggregate, do not appear to be particularly research-intensive or innovative.
I then turn to examining one subset of small businesses that do appear to excel at innovation: venture capital-backed start-ups. I highlight some of the venture-backed firms’ contributions. I also discuss why the success of such firms is not accidental. In particular, I highlight the key problems that the financing of small innovative companies pose, as well as some of the key mechanisms that venture investors employ to guide the innovation process. It is not surprising, then, that venture capital investments are concentrated in information technology industries, and that they appear to spur innovation.
Finally, I consider one set of policy issues related to small firms and innovation. In particular, I discuss some recent changes in the intellectual property protection system that appear to favor larger firms. I then argue that this may be an area that would reward increased attention by policy-makers interested in helping innovative small businesses in information technology and other high-technology industries.
1. Small Business and Innovation
A substantial but largely inconclusive literature examines the relationship between firm size and innovation. These studies have been handicapped by the difficulty of measuring innovative inputs and outputs, as well as the challenges of creating a sample that is free of selection biases and other estimation problems. While a detailed review of this literature is beyond the scope of this piece, the interested reader can turn to surveys by Baldwin and Scott  and Cohen and Levin .
Much of the work in this literature has sought to relate measures of innovative discoveries—whether R&D expenditures, patents, inventions, or other measures—to firm size. Initial studies were undertaken using the largest manufacturing firms; more recent works have employed larger samples and more disaggregated data (e.g., studies employing data on firms’ specific lines of business). Despite the improved methodology of recent studies, the results have remained inconclusive: even when a significant relationship between firm size and innovation has been found, it has had little economic significance. For instance, Cohen, Levin, and Mowery  concluded that a doubling of firm size only increased the ratio...