The R&D Investment-Uncertainty Relationship: Do Competition and Firm Size Matter?

Uncertainty is intrinsic to research and development (R&D) and has a fundamental influence on the decision to invest in such activities. Real options theoretical models with irreversible investment are a natural starting point for understanding how uncertainty influences R&D investment. When returns are uncertain and firms have the opportunity to delay investment, these models predict higher levels of uncertainty will be associated with lower levels of current R&D investment. Other theoretical work, however, suggests this "option to delay" investment may not be valuable when firms face competitive pressure or when R&D investments create valuable growth opportunities. These mediating factors suggest the direction of the effect of uncertainty on R&D investment is ambiguous. This paper contributes to the literature by looking at how competition and firm size affect the R&D investment-uncertainty relationship. We use an intuitively appealing measure of firm-level uncertainty along with panel data to show that firms invest less in current R&D as uncertainty about market returns increases. The effect of firm-specific uncertainty on R&D investment is smaller in concentrated markets – those where market power is higher and strategic rivalry is more intense. This is consistent with those theoretical models suggesting that growth options and the benefits of pre-emption offset the dampening effect of uncertainty. Further, the effect of uncertainty on R&D investment is attenuated for large firms. This is consistent with models highlighting that uncertainty increases incentives for current investment when there are growth options. Large firms may have greater economies of scope relative to small firms. This permits both R&D knowledge and inputs to be transferred to alternative uses within the firm and can be interpreted as a form of capacity building highlighted in the growth options literature.

Czarnitzki, Dirk and Andrew A. Toole (2008), The R&D Investment-Uncertainty Relationship: Do Competition and Firm Size Matter?, ZEW Discussion Paper No. 08-013, Mannheim, published in: Managerial and Decision Economics.