Businesses across the world discount new subscriptions, run introductory pricing and pour money into marketing before they see a return. Economists have historically treated this behaviour as separate from the real driver of growth: innovation. New modelling challenges this view, suggesting that winning customers matters as much as productivity, and in some sectors, more.

Some of the fastest-growing businesses of the past two decades have built themselves on the deliberate, and sometimes loss-making, pursuit of customers. Airbnb, for example, almost ran out of money in 2009 when its founders concluded that poor listing photography, rather than a lack of demand, was behind lacklustre results. They flew to New York, rented a camera and personally re-shot the platform's listings. As a result, they doubled bookings from those listings within a week, and the company built a professional photography program off the back of it. That early investment in customer trust eventually paid off at scale: after a net loss of US$352 million in 2021, Airbnb posted its first full-year GAAP profit in 2022, with net income of US$1.9 billion.

Uber pursued the same goal by different means, absorbing years of losses to build market share before profitability. Uber's own IPO prospectus disclosed operating losses of US$3 billion in 2016, US$4.1 billion in 2017 and US$3 billion in 2018, driven substantially by rider and driver incentive payments. That spending took years to pay off: after cutting headcount and scaling back driver incentives under chief executive Dara Khosrowshahi, Uber posted its first full-year net profit on a GAAP basis in 2023, with net income of about US$1.9 billion.

“It’s not ‘just’ foregone profits in the form of driver incentives or aggressive price discounts; firms spend enormous amounts of resources on actively trying to win customers through advertising and marketing,” said UNSW Business School of Economics Professor, Petr Sedláček, who recently co-authored a research paper, Customer Acquisition, Business Dynamism, and Aggregate Growth, together with Dr Marek Ignaszak from the European Commission's Joint Research Centre in Ispra, Italy.

“In fact, in the US, advertising alone amounts to roughly the same share of economic activity as R&D investment, and nearly two-thirds of R&D-performing listed companies also report advertising expenditures. These patterns are what made us ask whether investment in customers and expenditures on innovation are really separate decisions or not.”

Growth models have left out the customer base

Published in the Review of Economic Studies, the research paper explains how standard growth models assume firms compete on productivity alone, in a process known as creative destruction, where efficient firms displace inefficient ones. Dr Ignaszak and Prof. Sedláček point out that before a firm can compete on productivity, it needs customers to sell to.

The researchers cite discounted pricing for newspaper subscriptions, mobile phone plans, and gym memberships, as well as the longer-term pricing strategies that Airbnb, DoorDash, Netflix, and Uber use to build market share. In the model, this spending sits on the same footing as research and development as an investment (not an overhead).

“To align with the data further, the model also considered a second key channel of active customer accumulation – advertising expenditures with which firms directly try to convince customers to buy their products,” said Prof. Sedláček. In the data, smaller firms tend to grow faster, and they are also characterised by higher intensities of R&D and advertising expenditures. We wanted to understand whether these patterns were connected and if so, how.”

The model was calibrated to US company data from Compustat, Capital IQ and the Census Bureau's Business Dynamic Statistics, covering 1997 to 2019, alongside 70 years of national output and employment data. Its predictions held up against separate firm-level evidence: sales and marketing spending increase with lower markups and with higher research and development spending, and industries where customers are harder to win show weaker research and development spending.

Customer acquisition explains almost half of growth

The model found that a feedback loop exists between customers and innovation. Firms with larger customer bases earn more from each productivity gain because that gain applies to more sales, thereby raising the payoff from research and development. Firms that innovate successfully become more efficient, spend more on winning customers, and grow their customer base further. Each side strengthens the other.

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The researchers measured this loop against a counterfactual in which customer growth is held flat. Customer accumulation accounts for more than 40% of firm-level innovation rates, and almost 60% for firms under five years old. Across the entire economy, customer effects and the movement of customers toward fast-growing firms together account for nearly half of aggregate growth. Firms known as "gazelles," singled out in past research for rapid growth, may owe part of that growth to customer accumulation rather than productivity gains alone.

“This result was important because, traditionally, economic growth theory considered growing firms as superior in their productivity,” said Prof. Sedláček. “Our results pointed out that, while that may indeed still be part of the story, customer acquisition also plays an important role. This, in turn, is important for understanding the process of Schumpeterian creative destruction – which firms survive and which shut down – and what implications that may have for the aggregate economy.”

Growth subsidies work differently once customers are in the model

The researchers compared their full model against a version that strips out customer effects entirely, then tested two common policy tools: subsidies for research and development, and subsidies that lower the cost of staying in business.

Research and development subsidies proved roughly three times as effective at boosting growth once customer effects were accounted for. Cheaper research spending encourages more investment, which raises the payoff from winning more customers; the two effects compound.

"The broader policy lesson is that innovation can also be supported indirectly through demand measures"

PETR SEDLÁČEK

Subsidies that keep firms operating had the opposite result: growth fell further once customer effects were included. A firm with a large customer base can survive despite weak productivity; a firm with strong productivity can survive with few customers. Support that keeps firms in business for longer, therefore keeps some genuinely unproductive firms trading rather than making way for stronger entrants, and this effect is stronger once customer dynamics are built into the model.

Practical takeaways for business and policy

The research gives business leaders a case for treating customer spending as an investment that compounds, rather than a cost separate from research and development. Marketing spend and pricing strategy that build a lasting customer base raise the return on the innovation that follows.

For policymakers, the research is a warning against designing growth policy based on models that omit customer dynamics. Subsidy programs built without them risk understating the benefits of research and development incentives and the costs of broad support for struggling firms. Given that customer dynamics account for close to half of aggregate growth in this model, this is a sizeable blind spot to leave unexamined.

Learn more: Why innovation isn’t translating into productivity growth

“The broader policy lesson is that innovation can also be supported indirectly through demand measures,” said Prof. Sedláček. “For instance, public procurement can play a role by providing a stable, predictable source of demand. According to our model, this raises the value of R&D investment by partly securing firms’ market shares when monetising the innovation payoffs.”

Indeed, complementary US evidence shows that government R&D contracts that implicitly promise guaranteed demand can crowd in firms’ own scientific investment, Prof. Sedláček concluded.

5 recommendations for industry professionals

1. CEOs and strategy leaders: Assess customer acquisition and R&D as connected investment decisions rather than separate growth functions.
2. CMOs and growth leaders: Measure customer base growth alongside marketing spend and examine whether acquisition expands the return available from innovation.
3. CFOs: Incorporate customer base assumptions into investment planning while keeping management treatment separate from statutory accounting treatment.
4. R&D leaders: Include assumptions about market size and customer base when assessing the return on research spending.
5. Policy leaders: Include customer accumulation when modelling R&D subsidies, operating support and policies that affect firm entry, survival and growth.