Starting an R&D Project under Uncertainty
AbstractWe model a two-stage R&D project with an abandonment option. Two types of uncertainty influence the decision to start R&D. Demand uncertainty is modelled as a lottery between a proportional increase and decrease in demand. Technical uncertainty is modelled as a lottery between a decrease and increase in the cost to continue R&D. Both lotteries become more divergent when the difference between the outcomes of the lottery increases. A potential entrant is endowed with a superior technology and threatens to drive the incumbent out of the market. The incumbent has a time lead over the entrant and can obtain the same superior technology by completing the R&D project before the entrant can enter the market. We derive under which lottery probabilities more divergent demand and supply lotteries positively or negatively affect the decision to start R&D. We test the derived hypotheses using a unique dataset containing proxies for demand and technical uncertainty as well as perceived entry threat for about 4000 German firms in manufacturing and services (CIS IV). Strongly confirming our model predictions, we find that for firms facing lotteries where the good outcome is more likely to prevail (i) a 10% increase in the degree of divergence of the demand lottery increases the likelihood of undertaking R&D by 1.3% and (ii) a 10% increase in the degree of divergence of the supply lottery increases the likelihood of undertaking R&D by 1.5%. For firms facing a demand lottery where the bad outcome is more likely to prevail, a more divergent demand lottery decreases the probability of undertaking R&D significantly.
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Bibliographic InfoPaper provided by DRUID, Copenhagen Business School, Department of Industrial Economics and Strategy/Aalborg University, Department of Business Studies in its series DRUID Working Papers with number 08-09.
Date of creation: 2008
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Investment under uncertainty; R&D; demand uncertainty; technical uncertainty; entry threat;
Other versions of this item:
- Sabien Dobbelaere & Roland Iwan Luttens & Bettina Peters, 2009. "Starting an R&D Project under Uncertainty," Tinbergen Institute Discussion Papers 09-044/3, Tinbergen Institute.
- S. Dobbelaere & R. I. Luttens & B. Peters, 2009. "Starting an R&D project under uncertainty," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 09/585, Ghent University, Faculty of Economics and Business Administration.
- Dobbelaere, Sabien & Luttens, Roland Iwan & Peters, Bettina, 2009. "Starting an R&D project under uncertainty," CORE Discussion Papers 2009036, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
- D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- L12 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Monopoly; Monopolization Strategies
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