Starting an R&D Project under Uncertainty

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.