Dynamic contracting for innovation under ambiguity

Abstract

Outsourcing of research is commonly observed in knowledge-intensive industries such as biotech. We model innovation as an ambiguous stochastic process with dynamically consistent updating. We assume that the research labs are less ambiguity averse than the commercial firms. We characterize the optimal sequence of short-term contracts governing innovation, and show how it facilitates ambiguity-sharing. This ambiguity sharing agreement mitigates the dynamic moral hazard problem, resulting in monotonically decreasing investment and preventing equilibrium delay. Compared to an ambiguity-neutral policymaker's benchmark, the research alliances stop experimenting too early, and may liquidate the project even after being patented. The problems are structural, redesigned patent laws cannot solve both of these problems.