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Starting an R&D Project under Uncertainty

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  • Sabien Dobbelaere
  • Roland Iwan Luttens
  • Bettina Peters

Abstract

We 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 Info

Paper 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.

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Date of creation: 2008
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Handle: RePEc:aal:abbswp:08-09

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Web page: http://www.druid.dk/

Related research

Keywords: Investment under uncertainty; R&D; demand uncertainty; technical uncertainty; entry threat;

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  1. Howitt, Peter & Griffith, Rachel & Aghion, Philippe & Blundell, Richard & Bloom, Nick, 2005. "Competition and Innovation: An Inverted-U Relationship," Scholarly Articles 4481507, Harvard University Department of Economics.
  2. Pindyck, Robert S., 1993. "Investments of uncertain cost," Journal of Financial Economics, Elsevier, vol. 34(1), pages 53-76, August.
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  10. Darby, Julia, et al, 1999. "The Impact of Exchange Rate Uncertainty on the Level of Investment," Economic Journal, Royal Economic Society, vol. 109(454), pages C55-67, March.
  11. Lukach, R. & Kort, P.M. & Plasmans, J., 2007. "Optimal R&D investment strategies under the threat of new technology entry," International Journal of Industrial Organization, Elsevier, vol. 25(1), pages 103-119, February.
  12. Farzin, Y.H. & Huisman, K.J.M. & Kort, P.M., 1998. "Optimal timing of technology adoption," Open Access publications from Tilburg University urn:nbn:nl:ui:12-74049, Tilburg University.
  13. Weeds, Helen, 2002. "Strategic Delay in a Real Options Model of R&D Competition," Review of Economic Studies, Wiley Blackwell, vol. 69(3), pages 729-47, July.
  14. Dasgupta, Partha & Stiglitz, Joseph, 1980. "Industrial Structure and the Nature of Innovative Activity," Economic Journal, Royal Economic Society, vol. 90(358), pages 266-93, June.
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  16. Henley, Andrew & Carruth, Alan & Dickerson, Andy, 2003. "Industry-wide versus firm-specific uncertainty and investment: British company panel data evidence," Economics Letters, Elsevier, vol. 78(1), pages 87-92, January.
  17. repec:bla:restud:v:74:y:2007:i:2:p:391-415 is not listed on IDEAS
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