Why Demand Uncertainty Curbs Investment: Evidence from a Panel of Italian Manufacturing Firms

Abstract

From a theoretical point of view, uncertainty over the demand for a firm's product may not have clear effects on investments, because of the influence of a number of factors, such as the production technology and the amount of competition in the product market. Until now, a deeper investigation of the interplay of different factors in the temporal dimension has not been possible because the empirical research has been based on cross-section analysis. This omission makes biased estimates of the investment-uncertainty relationship likely. The aim of this paper is to extend the findings of the empirical literature by using a panel of Italian firms over the period 1996-2004, covering a complete business cycle. The availability of a panel of survey data on companies' investment plans, expected future sales and demand uncertainty allows us to account for unobservable individual firm differences, macroeconomic shocks and the temporal evolution of the investment-uncertainty relationship. A key finding of our paper concerns the role of the competition faced by Italian firms in 1996-2004. The gradual loss of market power experienced by Italian manufacturing firms along with the increasing flexibility of labour input may have weakened the negative effect of uncertainty on investment decisions. We show that, in repeated cross-section estimates, the omission of firm-specific effects together with the dynamic interplay described above, would have lead to misleading conclusions about the relevance of demand uncertainty in explaining investment decisions.