Externalities and Corporate Investment

Abstract

We show that investment patterns often associated with agency and information problems can emerge as rational responses to product-market rivalry. We establish this result using simultaneous and sequential models of innovative investment that balance two negative externalities. One externality arises when all competing firms invest, thus eroding the gains to innovation accruing to any one firm. Another externality arises when some firms do not invest and lose out to rivals who do innovate. The value of innovative investment therefore depends on the innovation's intrinsic value to each firm and the actions of all competitors. Our analysis can rationalize investment patterns that might appear suboptimal when these externalities are ignored. For instance, our simultaneous model can justify investment levels that might otherwise be interpreted as under or over-investment. Our sequential model shows that value-maximizing firms might optimally herd in their investment decisions. We present evidence supporting key aspects of both the simultaneous and sequential models.

Keywords: Investment, Externalities, Innovation, Competition