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We analyse the determinants of the decline in research productivity using panel data on manufacturing firms in the US for the period 1980-93. We focus on three factors: the level of demand, the quality of patents and technological exhaustion. We develop an index of patent 'quality' using detailed patent information and show that using multiple indicators substantially reduces the measured variance in quality. Research productivity at the firm level is inversely related to patent quality and the level of demand, as predicted by theory and patent quality is positively associated with the stock market value of firms.Research productivity, as typically measured by the ratio of patents to R&D, has declined sharply over the last 40 years, in many different industries and countries (see Figure 1 for US experience). By 1990 the number of patents produced per US scientists and engineers (S&E) had fallen to just 55% of its 1970 level, with even steeper declines in Europe (Evenson, 1984(Evenson, , 1993. At any time there are also large cross-sectional differences in measured research productivity across industries and firms (Evenson, 1984;Griliches, 1990). These facts have attracted increasing attention from academics and international organisations such as the OECD (1991) because of concern about the apparent slowdown in total factor productivity since the late 1960s. But scholarly observers have voiced concerns about the decline in research productivity for a long time. As Griliches (1990) points out, aggregate patent numbers have fluctuated widely and have grown more slowly than investments over much of the twentieth century.This fall in research productivity could simply derive from diminishing returns in the 'knowledge production function'. As markets expand, the private returns to R&D increase. The induced rise in the level of R&D investment leads to a fall in research productivity. A number of quality-ladder growth models have formalised this relationship, showing that in equilibrium research productivity should fall with growth in demand (Caballero and Jaffe, 1993;Kortum, 1993). Empirical studies using sector-level data for the US and other countries typically find that market size does matter. However, demand growth is not sufficient to explain the observed declines in R&D productivity as measured by the ratio of patents to R&D inputs (Evenson, 1993;Kortum, 1993).Thus the evidence of declining research productivity raises the spectre of technological exhaustion -getting less inventive output for any given level of

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