R&D investments in the presence of knowledge spillover and debt financing: can risk-shifting cure free-riding?
Manufacturing & Service Operations Management,
January (1st Quarter/Winter)
In an industry with knowledge spillover and debt financing, equilibrium investments in R&D projects are subject to three economic forces. First, knowledge spillover among firms enables free dissemination of new technologies and produces investment synergies. Second, knowledge spillover also causes free-riding: in equilibrium firms under-invest in R&D expecting to benefit from investments by others. Third, debt financing creates incentive for risk-shifting: equity holders over-invest in riskier R&D projects. We study how interactions among these forces affect a firm's investment decisions and equilibrium industry outcomes using a three-stage game between two firms and the external debt market. We characterize sub-game perfect, Pareto-dominant equilibria and show that for some parameter choices, free-riding and risk-shifting cancel each other in the decisions of individual firms, resulting in the first-best investments. Interestingly, for some cases, the equilibrium with first-best investments becomes possible only when risk-shifting by one firm enables free-riding by the other firm. We also show that debt can be used by firms as a commitment device in a multi-stage game. This value of debt is shared with investors, who can earn positive profits despite being perfectly competitive. This enriches the understanding of the financial "pecking-order theory" by showing that even firms with unlimited internal capital may prefer external debt financing.