The literature suggests that public research and development (R&D) subsidies may reduce market failures affecting private R&D investment caused by incomplete appropriability of knowledge and financial constraints due capital market imperfections. Drawing on the theory of investment under uncertainty, this paper argues that public R&D subsidies increase business R&D investment through an additional mechanism – mitigating the effects of market uncertainty on R&D investment in markets for new products. Using a sample of German manufacturing firms, we show that market uncertainty indeed reduces R&D investment, and that R&D subsidies mitigate the effect of uncertainty. Our findings suggest that public policies aimed at increasing business R&D investment can achieve this objective by reducing the degree of uncertainty in the demand for innovative products.
Real Options Theory Uncertainty R&D Censored Regression