On the Road to Innovation: The Role of Venture Capital

Abstract

We provide empirical evidence that innovation is a result of both supply-side and demand-side factors. We find that positive shocks to product demand trigger innovation as firms strive to keep their competitive advantage; and that a firm's innovation response to this shock is dependent upon the quality of that firm's supply-side innovation environment. To do this we (i) exploit a shift in product demand generated by Medicare approvals for reimbursement coverage of medical devices and (ii) construct indexes that proxy for the quality of the supply-side innovation environment based on venture capital availability, number of research universities, as well as National Institute of Health (NIH) grants. Employing a triple-difference approach, we show empirically that innovation is significantly greater for firms that experience a positive shock to demand due to the Medicare approvals, when they are exposed to a more favorable supply-side innovation environment. This finding implies that both the demand-side trigger for innovation and the supply-side innovation environment are crucial for innovation to take place.