1. UNCERTAINTY & THE DYNAMICS OF R&D Nick 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. Physical capital usually modeled as cumulated investment While knowledge capital usually modeled as cumulated R&D KNOWLEDGE CAPITAL AND PHYSICAL CAPITAL HAVE SIMILAR LAWS OF MOTION….

6. Physical capital adjustment costs typically arise from directly changing the capital stock – for example resale loss on equipment …BUT DIFFERENT ADJUSTMENT COSTS FOR CHANGING THEIR MOTION 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. So knowledge capital adjustment costs C G (ΔΔG t ) are an order of difference apart from physical capital adjustment costs C K (ΔK t ) 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 STOCK PHYSICAL CAPITAL AND, FLOW KNOWLEDGE CAPITAL ADJUSTMENT COSTS Interestingly, Christiano, Eichenbaum and Evans (2005) assume flow adjustment costs for capital C K (ΔΔK t ) – 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. Set up a model – in summary 1 : Firms uncertain over future “business conditions” dY t = Y t (μ + σ t dZ t )dZ t ~ N(0,1) Uncertainty (σ t ) varies over time, following an AR(1) process σ t = σ t-1 + ρ σ (σ* - σ t-1 ) + σ S S t dS t ~ N(0,1) BUILD MODEL OF R&D UNDER UNCERTAINTY (1) 1 Full details in the paper, program on www.stanford.edu/~bloom

10. There are adjustment costs for changing R&D –Baseline assumes these are linear: C= λ |R t – R t-1 | –Also show results for quadratic costs: C= λ (R t – R t-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 BUILD MODEL OF R&D UNDER UNCERTAINTY (2)

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

12. 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 σ t =5% σ t =50% σ t =20% σ t =5% σ t =20% σ t =50% Business Conditions, Log (y t ) Current R&D, r t Lagged R&D, r t-1 An R&D “delay effect”

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

14. Knowledge Capital Adjustment Costs Simulation & Intuition Implications

15. 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: (r t is R&D, Δy t is change in business conditions, σ t is uncertainty) with the prediction is β 4 0 “CAUTION EFFECT” IMPLICATIONS OF UNCERTAINTY FOR R&D

16. Impact of uncertainty on R&D depends on the change in R&D “DELAY EFFECT” IMPLICATIONS OF UNCERTAINTY Marginal impact of uncertainty on R&D R&D decreasing* R&D increasing Knowledge stock decreasing +- Knowledge stock increasing +- *If R&D rates depreciate at rate δ R, then condition is r t <(1- δ R )r t-1

17. Impact of uncertainty on investment depends on change in capital Marginal impact of uncertainty on investment Investment decreasing* Investment increasing Capital stock decreasing* ++ Capital stock increasing -- *After controlling for depreciation, K t <(1- δ K )K t-1 “DELAY EFFECT” IMPLICATIONS OF UNCERTAINTY ON INVESTMENT (FOR COMPARISON TO R&D)

18. 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 COMBINED “DELAY EFFECT” IMPLICATIONS

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