In order to assess the relationship between internal and external innovative inputs and innovative output at firm level, a knowledge production function is estimated for a representative sample of Italian manufacturing firms over the period 1998-2003. To account for endogeneity of R&D effort in the knowledge production function, we estimate a Heckman selection model on R&D decisions. Results support the view that R&D intensity is positively linked to firm size, age and human capital endowment as well as to higher exposure to international competitive pressure. Then, the knowledge production function is estimated using a standard probit, where the probability to innovate of each firm depends upon intramural R&D effort, regional and industrial spillovers and on a vector of interaction and control variables. Our measures of external knowledge, which circulates and potentially transfers across firms belonging to the same geographical or industrial spaces, are based on predicted values for R&D effort in the region and industry respectively. Our results suggest a positive relationship between sectoral spillovers and innovation; knowledge diffusion in the regional space positively impacts on the probability to innovate of the recipient firm only if the latter has an appropriate endowment of human capital
