Direct demand-pull and indirect certification effects of public procurement for innovation

Public procurement has been increasingly adopted as a demand-side policy instrument to stimulate innovation, but empirical evidence on the effectiveness of public procurement remains scarce especially evidence using firm-level data. This paper theoretically analyzes the demand-pull and certification mechanisms through which public procurement can lead to innovation and empirically examines and disentangles their impacts on firms’ innovation outcomes. While the demand-pull effect is well acknowledged, we argue that public procurement may also act as a certificate or signal to external investors and may stimulate innovation by alleviating the financial constraints of innovating firms. Based on a unique sample of high-tech firms in China, empirical results indicate that public procurement significantly increases firms’ R&D investment, promotes high-tech product sales, and enhances firms’ access to external finance. A quantitative framework of causal mediation analysis is used to disentangle the direct demand-pull and indirect certification effects. Despite the dominance of the demand-pull effect, the certification effect is found to be more pronounced for financially constrained small and young firms. Our study provides justification for the use of public procurement as an innovation policy instrument and implications for better policy design and implementation.