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Dynamic Contracting for Innovation Under Ambiguity

  • Economics Discussion Papers
  • July 2, 2019
  • Swagata Bhattacharjee,
  • Swagata Bhattacharjee

Outsourcing of research is commonly observed in knowledge-intensive industries e.g. biotech. We model innovation as an ambiguous stochastic process, and assume that the commercial firms are more ambiguity averse than the research labs. We characterize the optimal sequence of short-term contracts governing innovation, and show how it facilitates ambiguity sharing. The firm's ambiguity aversion mitigates the dynamic moral hazard problem, resulting in monotonically decreasing investment and prevents equilibrium delay. However, compared to an ambiguity-neutral policymaker's benchmark, the research alliance stops experimenting earlier, and may liquidate the project even after being patented; even redesigning patent laws cannot solve both of the problems.

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