LECTURE 4
Why is innovation risky for investors?
Risk of failure
Takes a long time to materialize
Intangible output that leads to appropiability problems
While innovation pays off on average, profitability of specific projects is uncertain
+ innovation has low inside collateral value
What are the assymetric information problems when it comes to financing innovation?
Moral hazard: investors don't know if firm's are acting in the inventors' best interest
Adverse selection: investors don't know which are the best firms to invest to minimize risk
Why markets do not take care of underfinancing of innovation?
Because VC funds are underdevelopped
In the model for constrainted firms, what does the marginal rate of return depend of?
Firm's innovation capacity IC_i
Firm's level of expenditure or investment I_i
Firm and industry characteristics X
In the model of constrainted firms, what does the marginal cost of capital depend of?
The firm's level of investment I_i
The firm's internal dunds IF_i
Opportunity cost: other firm's return R
Firm's creditworthiness W_i
Which effect do we expect for two constrainted firms with the same internal funds but different innovation capacity when accessing the credit market?
Possitive effect on both firm's innovation, but a greater possitive effect in the firm with higher innovation capacity
Which effect do we expect on two constrainted firms with the same innovation capacity but different internal funds when getting acess to the credit market?
Possitive effect on both firms' innovation but greater possitive effect on the firm with lower IF
Which kind of spending is more constrainted? Why?
Research
Because it is more uncertain (takes more time to develop and it has a higher probability of getting no returns), the outcome is often tacit knowledge, so no tangible assets or property rights are obtained at the end.
Empirical evidence that, while routine R&D is not affected by a firm's creditworthiness, cutting-edge is, indicating that the latter is more sensitive to financial constraints.
How is R&D typically financed, and why?
R&D is typically financed with internal funds because external investors tend to prefer other kinds of investment since R&D investment is more risky and has a low inside collateral value. Furthermore, they face asymmetric information issues (moral hazard and adverse selection).
As a consequence, investors demand a higher rate of return for R&D projects.
What kinds of firms are most likely to be financially constrained? How can innovation policy adjust to that (this question also involves elements from other lectures).
High-tech start ups and small firms.
R&D subsidies and tax credits increase firm's IF -> less credit constrainted
What are the “market failures” related to innovation?
Appropriability -> firms fail to fully capture the returns of their R&D investment -> private rate of return of R&D is lower than the public one -> not enough incentives to invest
Financing constraints -> uncertainity and assymetric information make investors demand higher return for R&D investments than other type of investments