Swallow Poison to Innovate: R&D Investment under Financial Constraints and Competition

Abstract

I build a dynamic model to examine how financial constraints and competition affect firms’ research and development (“R&D”) strategies. I show that first, financially constrained firms with risky cash flows can optimally overinvest relative to the first best; this is due to the project termination risk imposed by constraints, and the discovery process has to be “accelerable” (can be expedited by heavier investment). Second, strategic interactions lead to an inverted-U shaped best response of an unconstrained firm’s investment against its constrained competitor. Preemption by a constrained firm results in some market equilibria. The model generates new testable implications regarding R&D strategies.