UNCERTAINTY & THE DYNAMICS OF R&D Nick Bloom (Stanford, CEP & NBER) January 2007

1. UNCERTAINTY & THE DYNAMICS OF R&DNick Bloom (Stanford, CEP & NBER) January 2007

2. UNCERTAINTY APPEARS TO VARY OVER TIME • Uncertainty appears to be counter-cyclical rising by 50% to 100% in recessions (Schwert, 1989) • Uncertainty also appears to jump 100% to 200% after major economic and political shocks (Bloom, 2006)

3. BUT WHAT IS THE REAL-OPTIONS IMPACT OF TIME VARYING UNCERTAINTY ON R&D? • Literature notes two effects of temporary rises in uncertainty: • “Delay effect” generating a temporary slowdown in hiring, investment and productivity as firms pause activity • “Caution effect” reducing the responsiveness of investment and hiring to any stimulus • But what about R&D – surely the extension is obvious? • In fact it is not - different adjustment costs of knowledge capital (versus physical capital & labor) generate different RO effects

4. Knowledge Capital Adjustment Costs Simulation and Intuition Implications

5. KNOWLEDGE CAPITAL AND PHYSICAL CAPITAL HAVE SIMILAR LAWS OF MOTION…. • Physical capital usually modeled as cumulated investment • While knowledge capital usually modeled as cumulated R&D

6. …BUT DIFFERENT ADJUSTMENT COSTS FOR CHANGING THEIR MOTION • Physical capital adjustment costs typically arise from directly changing the capital stock – for example resale loss on equipment • Knowledge capital is intangible and not (easily) bought/sold. Instead it is adjusted by changing R&D, the flow rate • But the adjustment costs for changing R&D are similar to those for changing capital – for example resale loss on R&D equipment

7. STOCK PHYSICAL CAPITAL AND, FLOWKNOWLEDGE CAPITAL ADJUSTMENT COSTS • So knowledge capital adjustment costs CG(ΔΔGt)are an order of difference apart from physical capital adjustment costs CK(ΔKt) • This is because adjustment costs for physical capital arise from changing the stock while for knowledge from changing the flow • This distinction plays a critical role in real-options effects • Interestingly, Christiano, Eichenbaum and Evans (2005) assume flow adjustment costs for capital CK(ΔΔKt) – that is it is costly to change investment rates due to decision making costs etc....

8. Knowledge Capital Adjustment Costs Simulation and Intuition Implications

9. BUILD MODEL OF R&D UNDER UNCERTAINTY (1) • Set up a model – in summary1: Firms uncertain over future “business conditions” dYt = Yt (μ + σt dZt) dZt ~ N(0,1) Uncertainty (σt )varies over time, following an AR(1) process σt = σt-1 + ρσ(σ* - σt-1) + σS St dSt ~ N(0,1) • 1 Full details in the paper, program on www.stanford.edu/~bloom

10. BUILD MODEL OF R&D UNDER UNCERTAINTY (2) • There are adjustment costs for changing R&D • Baseline assumes these are linear: C= λ |Rt – Rt-1| • Also show results for quadratic costs: C= λ (Rt – Rt-1)2 • Assume for tractability that labor and capital costless to adjust • Can show unique, continuous, unique analytical solution exists. But need numerical methods to solve for particular parameters

11. The R&D “caution effect” Figure 1: Higher uncertainty makes R&D more persistent over time and less responsive to current business conditions • Medium uncertainty,σt=20% • Current R&D, rt • Low uncertainty,σt=5% • Lagged R&D, rt-1 • High uncertainty,σt=50% • Business Conditions, Log (yt)

12. An R&D“delay effect” Figures 2a and 2b: The effect of uncertainty on R&D is negative if R&D is increasing, and positive if R&D is falling • Lagged R&D, rt-1 • σt=20% • Current R&D, rt • Current R&D, rt • σt=5% • σt=50% • σt=50% • σt=5% • Lagged R&D, rt-1 • σt=20% • Business Conditions, Log (yt) • Business Conditions, Log (yt)

13. Figure 3: With only quadratic adjustment costs there are no real options effects of uncertainty on R&D • σt=20% • σt=5% • σt=50% • Current R&D, rt • Lagged R&D, rt-1 • Business Conditions, Log (yt)

14. Knowledge Capital Adjustment Costs Simulation & Intuition Implications

15. “CAUTION EFFECT” IMPLICATIONS OF UNCERTAINTY FOR R&D • Firms will be less responsive to external stimulus – like R&D tax credits – in periods of high uncertainty • Could be empirically investigated by estimating something like: • (rt is R&D, Δyt is change in business conditions, σt is uncertainty) • with the prediction is β4<0 and β5>0

16. “DELAY EFFECT” IMPLICATIONS OF UNCERTAINTY • Impact of uncertainty on R&D depends on the change in R&D

17. “DELAY EFFECT” IMPLICATIONS OF UNCERTAINTY ON INVESTMENT (FOR COMPARISON TO R&D) • Impact of uncertainty on investment depends on change in capital

18. COMBINED “DELAY EFFECT” IMPLICATIONS • Higher uncertainty will tend to: R&D • Reduce R&D when R&D is rising – i.e. coming out of a recession and start of a boom • Reduce changes in R&D, inducing a more lagged response Investment (or hiring) • Reduce investment when capital is rising – i.e. during a boom • Reduce level of response, flattening fluctuations

19. CONCLUSIONS • Uncertainty does appear to change strongly over time • This will induce important “delay” and “cautionary” real-options effects on investment and hiring • Will induce somewhat different “delay” and “cautionary” effects on R&D due to flow (rather than stock) adjustment costs • slowing responsiveness • increasing persistence • Hope that future empirical research will test these predictions

20. BACK-UP

21. US stock market volatility 1962 to 2005 Black Monday* 9/11 Enron Russia & LTCM Franklin National Cambodia,Kent State Gulf War II Monetary turning point JFK assassinated OPEC I Asian Crisis Afghanistan Cuban missile crisis Gulf War I OPEC II Annualized standard deviation (%) Actual Volatility Implied Volatility Source: Bloom (2006)