Essays on the production of innovation

Abstract

Innovation is central to both the competitive strategy of many firms and gains in productivity that lead to economic growth. How do we improve our ability to produce innovations? This dissertation studies three aspects of this question: staged development, vertical integration and venture capital. Staged development, common in many innovative settings including biotech and venture capital of ideas, involves partially funded an idea with the goal of learning more about that idea before additional funding is provided. My result suggests there are cases where committing to ideas, avoiding staged development, can lead to better outcomes. Staged development has the potential of distorting effort to an extent that outweighs any benefit provided by its implicit option value. Research units pursuing innovations can either be integrated within the firm exploiting those innovations or kept as a separate entity. I find that integration leads to a higher rate of new innovations. Separating the research unit can reduce its appetite for risk, changing both the rate and direction of innovation. Finally, uncertainty surrounds strategies to exploit innovations: new ideas by definition have not been tested by market forces. I show how venture capital plays a key role in resolving this uncertainty for entrepreneurs with new ideas. Specifically, venture capital provides the most value for entrepreneurs that are themselves the most uncertain about the underlying value of their ideas.