Innovation, Competition, and Investment Timing

in Developments in Finance and Accounting, Research Day
May 14th, 2012

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Yrjo Koskinen

Finance

Authors: Yrjo Koskinen and Joril Maeland

In a real options framework, we provide a model of innovative activity where multiple agents compete against each other by submitting investment proposals to the principal. Competition helps to speed up innovation not only because multiple agents are working on the same problem, but also because competition helps to solve the agency problems involved. In our model the principal asks proposals from n-number of agents and contracts with the agent who comes up with the best proposal. Agents will have to provide costly and unobservable effort. While working on the proposal agents will also privately learn the quality of their proposals. Multiple proposals make it easier to elicit truthful information from the agents, but all the efforts put into those proposals have to be compensated for. A key insight from the model is that the principal has less need to delay investments because competition among agents makes lying about the quality less profitable for the agents. We show that when the number of agents is endogenous, agents’ information rents are completely dissipated and the agency problem is reduced to a pure moral hazard problem. As a consequence the first best investment policy is always achieved and innovations are implemented earlier.