ABSTRACT. The Small Business Innovation Research(SBIR) program in the United States is one of the most impor-tant public policy programs, with a goal of generating innov-ative hi-technology firms and promoting competitiveness andgrowth. The purpose of this paper is to describe the SBIR,explain why it has emerged as an important policy instrument,and provide an evaluation of the impact of the SBIR. Thefindings of this paper suggest that the SBIR has generallyaccomplished its mission by contributing to the creation ofhigh-technology small firms and enhancing U.S. competi-tiveness.

1. Introduction

As recently as a decade ago, there were seriousconcerns about the ability of the United States towithstand competition in the global economy,create jobs and continue to develop. LesterThurow bemoaned that the United States was“losing the economic race,”1 because, “Today it’svery hard to find an industrial corporation inAmerica that isn’t in really serious trouble basi-cally because of trade problems. . . . The system-atic erosion of our competitiveness comes fromhaving lower rates of growth of manufacturingproductivity year after year, as compared with therest of the world” (Thurow, 1985, p. 23). W.W.Rostow predicted a revolution in economic policy,concluding that,”The United States is entering anew political era, one in which it will be preoc-cupied by increased economic competition fromabroad and will need better cooperation at hometo deal with this challenge.”2

In the influential study,

Made in America,directed by the leaders of the MIT Commission onIndustrial Productivity, Michael L. Dertouzos,Richard K. Lester, and Robert M. Solow, a teamof 23 scholars, spanning a broad range of disci-plines and backgrounds, reached the conclusionthat for the United States to restore its interna-tional competitiveness, it had to adapt the types ofpolicies targeting the leading corporations preva-lent in Japan and Germany.

The last decade has seen a reemergence of com-petitiveness, innovative activity and job genera-tion in the United States. Not only was thiseconomic turnaround largely unanticipated bymany scholars and members of the policy com-munity, but what was even more surprising thanthe resurgence itself was the primary source –small firms. As scholars began the arduous task ofdocumenting the crucial role played by SMEs inthe United States as a driving engine of growth,job creation and competitiveness in global markets(Audretsch, 1995), policy makers responded witha bipartisan emphasis on policies to promoteSMEs.3 For example, in his 1993 State of theUnion Address to the country, President BillClinton proposed, “Because small business hascreated such a high percentage of all the new jobsin our nation over the last 10 or 15 years, our planincludes the boldest targeted incentives for smallbusiness in history. We propose a permanentinvestment tax creditor the small firms in thiscountry.”4 The Republican response to Clintonwas, “We agree with the President that we haveto put more people to work, but remember this: 80to 85 percent of the new jobs in this country arecreated by small business. So the climate forstarting and expanding businesses must beenhanced with tax incentives and deregulation,

Standing on the Shoulders of Midgets: The U.S. Small Business Innovation Research Program (SBIR) David B. Audretsch

Small Business Economics 20: 129–135, 2003. 2003 Kluwer Academic Publishers. Printed in the Netherlands.

Final version accepted on January, 2001

Ameritech Chair of Economic Development & DirectorInstitute for Development StrategiesIndiana UniversityBloomington IN 47405U.S.A.

rather than imposing higher taxes and more gov-ernmental mandates.”5

In fact, one of the responses of U.S. policy tothe competitiveness crisis of the 1970s and early1980s was to enact the Small Business InnovationResearch Program (SBIR). The mandate of theSBIR was to enhance U.S. competitiveness by pro-moting innovative and high-technology smallfirms. The purpose of this paper is to explain thelink between international competitiveness and thepromotion of small firms as a policy response toglobalization, as well as to provide an evaluationof the SBIR.

In the second section of this paper we documenthow the comparative advantage has shifted awayfrom the traditional factors of production towardsknowledge-based economic activity. The implica-tions of knowledge for entrepreneurship isexplained in the third section. In the fourth sectionthe role of the SBIR in promoting entrepreneur-ship in the U.S. is evaluated. Finally, in the fifthsection, a summary and conclusions are provided.

2. Globalization and the shifting source ofcomparative advantage

Globalization has triggered a virtual spatial revo-lution in terms of the geography of production.6

The (marginal) cost of transforming informationacross geographic space has been rendered to vir-tually nothing. Confronted with lower cost com-petition in foreign locations, producers in thehigh-cost countries have three options apart fromdoing nothing and losing global market share: (1)reduce wages and other production costs suffi-ciently to compete with the low-cost foreign pro-ducers, (2) substitute equipment and technologyfor labor to increase productivity, and (3) shift pro-duction out of the high-cost location and into thelow-cost location.

Many of the European and American firms thathave successfully restructured resorted to the lasttwo alternatives. Substituting capital and tech-nology for labor, along with shifting production tolower-cost locations has resulted in waves ofCorporate Downsizing throughout Europe andNorth America. At the same time, it has gener-ally preserved the viability of many of the largecorporations. As record levels of both Europeanand American stock indexes indicate, the compa-

nies have not generally suffered. For example,between 1979 and 1995 more than 43 million jobswere lost in the United States as a result of cor-porate downsizing.7 This includes 24.8 millionblue-collar jobs and 18.7 million white-collar jobs.Similarly, the 500 largest U.S. manufacturing cor-porations cut 4.7 million jobs between 1980 and1993, or one quarter of their work force.8 Perhapsmost disconcerting, the rate of corporate down-sizing has apparently increased over time in theUnited States, even as the unemployment rate hasfallen. During most of the 1980s, about one in 25workers lost a job. In the 1990s this has risen toone in 20 workers.

Much of the policy debate responding to thetwin forces of the telecommunications revolutionand increased globalisation has revolved arounda trade-off between maintaining higher wages butsuffering greater unemployment versus higherlevels of employment but at the cost of lower wagerates. There is, however, an alternative. It does notrequire sacrificing wages to create new jobs, nordoes it require fewer jobs to maintain wage levelsand the social safety net. This alternative involvesshifting economic activity out of the traditionalindustries where the high-cost countries of Europeand North America have lost the comparativeadvantage and into those industries where thecomparative advantage is compatible with bothhigh wages and high levels of employment –knowledge based economic activity.

Globalisation has rendered the comparativeadvantage in traditional moderate technologyindustries incompatible with high wage levels. Atthe same time, the emerging comparative advan-tage that is compatible with high wage levels isbased on innovative activity. For example,employment has increased by 15 percent in SiliconValley between 1992 and 1996, even though themean income is 50 percent greater than in the restof the country.9

The global demand for innovative products inknowledge-based industries is high and growingrapidly; yet the number of workers who can con-tribute to producing and commercializing newknowledge is limited to just a few areas in theworld. Economic activity based on new knowledgegenerates higher wages and greater employmentopportunities reflecting the exploding demand fornew and improved products and services. There

130 David B. Audretsch

are many indicators reflecting the shift in the com-parative advantage of the high-wage countriestowards an increased importance of innovativeactivity. For example, Kortum and Lerner (1997,p. 1) document an unprecedented jump inpatenting in the United States, as evidenced by theexplosion in applications for United States patentsby American inventors since 1985. Throughoutthis century, patent applications fluctuated withina band between 40,000–80,000 per year. Bycontrast, in 1995 there were over 120,000 patentapplications. Similarly, Berman et al. (1997) haveshown that the demand for less skilled workers hasdecreased dramatically throughout the OECD,while at the same time, the demand for skilledworkers has exploded.

3. Entrepreneurship in a knowledge economy

That SMEs would emerge as becoming moreimportant seems to be contrary to many of the con-ventional theories of innovation. The starting pointfor most theories of innovation is the firm. In suchtheories the firms are exogenous and their perfor-mance in generating technological change isendogenous (Arrow, 1962). For example, in themost prevalent model found in the literature oftechnological change, the model of the knowledgeproduction function, formalised by Zvi Griliches(1979), firms exist exogenously and then engagein the pursuit of new economic knowledge as aninput into the process of generating innovativeactivity. The most decisive input in the knowledgeproduction function is new economic knowledge.Knowledge as an input in a production functionis inherently different than the more traditionalinputs of labour, capital and land. While theeconomic value of the traditional inputs is rela-tively certain, knowledge is intrinsically uncertainand its potential value is asymmetric acrosseconomic agents.10 The most important, althoughnot the only source of new knowledge is consid-ered to be research and development (R&D).Other key factors generating new economicknowledge include a high degree of human capital,a skilled labour force, and a high presence ofscientists and engineers.

There is considerable empirical evidence sup-porting the model of the knowledge productionfunction. This empirical link between knowledge

inputs and innovative output apparently becomesstronger as the unit of observation becomesincreasingly aggregated. For example, at the unitof observation of countries, the relationshipbetween R&D and patents is very strong. The mostinnovative countries, such as the united States,Japan and Germany, also tend to undertake highinvestments in R&D. By contrast, little patentactivity is associated with developing countries,which have very low R&D expenditures.Similarly, the link between R&D and innovativeoutput, measured in terms of either patents or newproduct innovations is also very strong when theunit of observation is the industry. The most inno-vative industries, such as computers, instrumentsand pharmaceuticals also tend to be the most R&Dintensive. Audretsch (1995) finds a simple corre-lation coefficient of 0.74 between R&D inputs andinnovative output at the level of four-digit standardindustrial classification (SIC) industries. However,when the knowledge production function is testedfor the unit of observation of the firm, the linkbetween knowledge inputs and innovative outputbecomes either tenuous and weakly positive insome studies and even non-existent or negative inothers. The model of the knowledge productionfunction becomes particularly weak when smallfirms are included in the sample. This is not sur-prising, since formal R&D is concentrated amongthe largest corporations, but a series of studies hasclearly documented that small firms account for adisproportional share of new product innovationsgiven their low R&D expenditures.

The breakdown of the knowledge productionfunction at the level of the firm raises the question,Where do innovative firms with little or no R&Dget the knowledge inputs? This question becomesparticularly relevant for small and new firmsthat undertake little R&D themselves, yet con-tribute considerable innovative activity in newlyemerging industries such as biotechnology andcomputer software (Audretsch, 1995). One answerthat has recently emerged in the economics liter-ature is from other, third-party firms or researchinstitutions, such as universities. Economic knowl-edge may spill over from the firm conducting theR&D or the research laboratory of a university.

Why should knowledge spill over from thesource of origin? At least two major channels ormechanisms for knowledge spillovers have been

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identified in the literature. Both of these spillovermechanisms revolve around the issue of appro-priability of new knowledge. Cohen and Levinthal(1989) suggest that firms develop the capacity toadapt new technology and ideas developed in otherfirms and are therefore able to appropriate someof the returns accruing to investments in newknowledge made externally.

By contrast, Audretsch (1995) proposes shiftingthe unit of observation away from exogenouslyassumed firms to individuals, such as scientists,engineers or other knowledge workers – agentswith endowments of new economic knowledge.When the lens is shifted away from the firm to theindividual as the relevant unit of observation, theappropriability issue remains, but the questionbecomes, How can economic agents with a givenendowment of new knowledge best appropriate thereturns from that knowledge? If the scientist orengineer can pursue the new idea within the organ-isational structure of the firm developing theknowledge and appropriate roughly the expectedvalue of that knowledge, he has no reason to leavethe firm. On the other hand, if he places a greatervalue on his ideas than do the decision-makingbureaucracy of the incumbent firm, he may chooseto start a new firm to appropriate the value of hisknowledge. In the metaphor provided by Albert O.Hirschman (1970), if voice proves to be ineffec-tive within incumbent organisations, and loyaltyis sufficiently weak, a knowledge worker mayresort to exit the firm or university where theknowledge was created in order to form a newcompany. In this spillover channel the knowledgeproduction function is actually reversed. Theknowledge is exogenous and embodied in aworker. The firm is created endogenously in theworker’s effort to appropriate the value of hisknowledge through innovative activity.

4. The public policy response

Public policy towards business has graduallyshifted from viewing the role of SMEs through thestatic lens towards the dynamic framework. Forexample, the United States Congress enacted theSmall Business Innovation Research (SBIR)program in the early 1980s as a response to theloss of American competitiveness in globalmarkets. Congress mandated each federal agency

with allocating around four percent of its annualbudget to funding innovative small firms as amechanism for restoring American internationalcompetitiveness. The SBIR provides a mandate tothe major R&D agencies in the United States toallocate a share of the research budget to innova-tive small firms. Last year the SBIR programamounted to around $1.2 billion. The SBIRconsists of three phases. Phase I is orientedtowards determining the scientific and technicalmerit along with the feasibility of a proposedresearch idea. A Phase I award provides anopportunity for a small business to establish thefeasibility and technical merit of a proposedinnovation. The duration of the award is sixmonths and can not exceed $70,000. Phase IIextends the technological idea and emphasizescommercialization. A Phase II Award is grantedto only the most promising of the Phase I projectsbased on scientific/technical merit, the expectedvalue to the funding agency, company capabilityand commercial potential. The duration of theaward is a maximum of 24 months and generallydoes not exceed $600,000. Approximately 40percent of the Phase I Awards continue on toPhase II. Phase III involves additional privatefunding for the commercial application of a tech-nology. A Phase III Award is for the infusion anduse of a product into the commercial market.Private sector investment, in various forms, istypically present in Phase III.

Under the Small Business Research andDevelopment Enhancement Act of 1992, fundingin Phase I was increased to $100,000, and in PhaseII to $750,000.

The SBIR was an offshoot of the SmallBusiness Investment Company (SBIC) program,which provided more than $3 billion to youngfirms between 1958 and 1969. During this periodthis amounted to more than three times the totalamount of private venture capital.

The SBIR represents about 60 percent of allpublic SME finance programs. Taken together, thepublic SME finance is about two-thirds as large asprivate venture capital. In 1995, the sum of equityfinancing provided through and guaranteed bypublic programs financing SMEs was $2.4 billion,which amounted to more than 60 percent of thetotal funding disbursed by traditional venturefunds in that year. Equally as important, the

132 David B. Audretsch

emphasis on SBIR and most public funds is onearly stage finance, which is generally ignored byprivate venture capital. Some of the most innov-ative American companies received early stagefinance from SBIR, including Apple Computer,Chiron, Compaq and Intel.

Through the Small Business InnovationResearch (SBIR) program, the National Institutesof Health (NIH) awarded $266 million in grantsto small firms for medical and biopharmaceuticalresearch. It is expected that the SBIR program atNIH will exceed $300 million in 1999.

In addition to the NIH, the United StatesDepartment of Defense also uses the SBIRprogram to fund biotechnology firms. Between1983 and 1997 there was more than $240 millionin SBIR awards for biotechnology companies fromthe Department of Defense. Phase I accounted for$47 million and Phase II accounted for $194million (Wessner, 2001).

To evaluate the impact of the SBIR on the com-mercial activities of SMEs, a large, comprehen-sive survey was undertaken by the U.S.NationalAcademy’s division on Science, Technology, andEconomic Policy (STEP) (Wessner, 2001). Inaddition, case studies were undertaken on the basisof detailed interviews with the founders, ownersand employees of over fifty firms (Scott, 2001;Link, 2001; Link and Scott; 2001). All of the casestudy firms had received SBIR assistance. Theyare dispersed across the United States and span abroad range of technologies, products and indus-tries. While some are new startups, others have aproven track record of success. These case studiesexamined the impact of the SBIR in a broadcontext. In particular, the results from evaluatingthe SBIR suggested that the benefits of the SBIRextends beyond the impact on the individual recip-ient firm. The social rate of return, which incor-porates this external positive impact, exceeds thepositive rate of return. There was no evidence ofa negative rate of return associated with the SBIR.There is compelling evidence that the SBIRprogram has had a positive impact on developingthe U.S. biotechnology industry. The benefits havebeen documented as:

• The survival and growth rates of SBIR recipi-ents have exceeded those of firms not receivingSBIR funding (Lerner and Kegler, 2001)

• The SBIR induces scientists involved inresearch to change their career path. Byapplying the scientific knowledge to com-mercialization, these scientists shift theircareer trajectories away from basic researchtowards entrepreneurship (Feldman, 2001 andAudretsch et al., 2001).

• The SBIR awards provide a source of fundingfor scientists to launch start-up firms thatotherwise would not have had access to alter-native sources of funding.

• SBIR awards have a powerful demonstrationeffect. Scientists commercializing researchresults by starting companies induce colleaguesto consider applications and the commercialpotential of their own research.

5. Conclusions

Globalization is shifting the comparative advan-tage in the United States away from being basedon traditional inputs of production, such as land,labor and capital, towards knowledge. As the com-parative advantage has become increasingly basedon new knowledge, public policy has respondedin two fundamental ways. The first has been toshift the policy focus away from the traditionaltriad of policy instruments essentially constrainingthe freedom of firms to contract – regulation,antitrust in the U.S., and public ownership ofbusiness. The policy approach of constraint wassensible as long as the major issue was how torestrain large corporations in possession of con-siderable market power. That this policy is lessrelevant in a global economy is reflected by thewaves of deregulation and privatisation. Instead,a new policy approach is emerging which focuseson enabling the creation and commercialisation ofknowledge. Examples of such policies includeencouraging R&D, venture capital and new-firmstartups. In particular, the new focus of SMEpolicies is to promote the first type of strategydeployed by SMEs to enhance global competi-tiveness – innovation. Probably the greatest andmost salient shift in SME policy over the lastfifteen years has been a shift from trying topreserve SMEs that are confronted with a cost dis-advantage due to size inherent scale disadvan-tages, towards promoting the startup and viabilityof SMEs involved in the commercialization of

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knowledge, or knowledge-based SMEs. The SBIRprogram of the United States is clearly one suchpolicy that has recognized the important role thatinnovative small firms play in generating com-petitiveness and growth.

Acknowledgements

I thank Frank Lichtenberg of Columbia Universityfor inspiring the title. I am grateful for the helpfulsuggestions of Donald Siegel, Chuck Wessner, AlLink, Maryann P. Feldman and John Scott as wellas participants at the University of NottinghamSeptember 2000 conference on Entrepreneurshipand Technology Policy.

Notes1 Lester Thurow, ‘Losing the Economic Race’, New YorkReview of Books, September 1984, pp. 29–31.2 W. W. Restow, ‘Here Comes a New Political Chapter inAmerica’, International Herald Tribune, 2 January 1987.3 For example, U.S. News and World Report (16 August,1993) reported, ‘What do Bill Clinton, George Bush and BobDole have in common? All have uttered one of the mostenduring homilies in American political discourse: That smallbusinesses create most of the nation’s jobs.’4 Cited from Davis et al. (1996, p. 298).5 Representative Robert Michel, House Minority Leader, inthe Republican Response to the 1993 State of the UnionAddress, cited from Davis et al. (1996, p. 298).6 According to The Economist, ‘The death of distance as adeterminant of the cost of communications will probably bethe single most important economic force shaping society inthe first half of the next century.’ ‘The Death of Distance’,The Economist, 30 September, 1995.7 ‘The Downsizing of America’, New York Times, 3 March,1996, p. 1.8 See Audretsch (1995).9 ‘The Valley of Money’s Delights’, The Economist, 29March, 1997, special section, p. 1.10 Arrow (1962) pointed out this is one of the reasons forinherent market failure.

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