Constructing a Price Deflator for R&D: Calculating the Price of Knowledge Investments as a Residual

We model the production and use of knowledge investment and show how the model can be used to infer the unknown price of knowledge using two approaches. The first is often used by national accounting offices and is based on costs in the knowledge-producing sector. We show this implicitly assumes no market power and no productivity in the production of knowledge. We set out an alternative approach that focuses on the downstream knowledge-using sector, the final output sector. The science policy practice of using the GDP deflator is a simple variant of this approach, while the full approach allows market power and implies backing out the price of R&D from final output prices, factor costs, and TFP. We estimate a R&D price for the United Kingdom from 1985 to 2005 using the full approach. The index falls strongly relative to the GDP deflator suggesting conventionally-measured real R&D is substantially understated.