Can mergers and acquisitions internalize positive externalities in funding innovation?

Abstract

Fundamental innovation usually involves huge upfront costs, but the benefits are spread across various sectors of the economy. Given the large costs and limited appropriability of the benefits associated with fundamental innovations, individual firms underinvest in these innovations relative to the socially optimal level. We find that mergers and acquisitions (M&As) can internalize the positive externalities by merging firms from both the user industries and the producer industries of an innovation. Using the US patent citation dataset, we define the user and producer relationship between each pair of industries and between each pair of industry and technological class. We then show that after a merger between an innovation user and an innovation producer (related M&As), the quantity and the quality of innovation output increase, and the increase is driven by targeted technological classes. In contrast, innovation output drops after unrelated mergers. Firms' internal resource allocation and financial flexibility play an important role in determining the effect of M&As on innovation.