Adapting to policy changes: How firms' R&D responses affect their performance

Abstract

While researchers have shown considerable interest in investigating the effects of external shocks—such as financial, health, or environmental crises—on innovation, the impact of policy shocks, another critical type of external shocks, on innovation has been largely overlooked despite the rising political and policy disruptions on a global scale. To address this research gap, this study examines how firms adjust their R&D investment in response to adverse policy shocks and the subsequent impact on their performance. The empirical context is an unexpected and significant subsidy reduction policy in the Chinese solar photovoltaic (PV) industry in 2018. Using a combination of propensity score matching and difference-in-differences models, we provide causal evidence of heterogeneous R&D adjustments amidst negative policy changes: while many firms reduced their R&D investment, some unexpectedly increased it. The policy shock, therefore, results in an overall insignificant impact on R&D investments across the industry. Furthermore, we find that increasing R&D investment as a reaction to policy shock is associated with an increase of 294 million renminbi (RMB) (approximately 40 million USD) in revenue or 30 million RMB (approximately 4 million USD) in profits on average. Our results suggest that R&D investments demonstrate a certain degree of resilience in the face of adverse policy shocks, serving as a protective measure for firms during such policy shifts. However, given the tendency of most firms to reduce R&D investments in response to adverse policy changes, these shifts may impede technological progress among less capable and resourceful firms, potentially jeopardizing their survival and contributing to a more concentrated market structure.