A Rational Rush Theory of Financing Innovations

Abstract

We propose a theory of rational Rush, emphasizing the quantity of rational over-investment contrast to the theory of irrational price Bubble. We illustrate an important friction when financing breakthrough innovations: non-excludability and spillover of uncertain knowledge due to imperfect IPR (Intellectual Property Rights, e.g. patent) protection. Facing a limited supply of new projects with uncertain return, investors make decisions about when and how many projects to invest. Investors' preemption motive will distort their incentives for patient learning about project return, thus inducing them to rush in to finance uncertain projects massively at a premature stage. A small positive news shock regarding the project return can greatly amplify over-investment and result large social inefficiency. On the other hand, information externality creates free-rider motive, which can also make under-investment possible. Our empirical finding based on sectoral Venture Capital investment shows that weak IPR protection lead to excessively high investment level and more procyclicality. Broader patent rights should be granted when the uncertainty of innovation is high, although the Rush prevention can induce more patent race at the early R&D stage, i.e. Rush-Race shifting.