Working Paper: CEPR ID: DP11082
Authors: David Dicks; Paolo Fulghieri
Abstract: We develop a theory of innovation waves, investor sentiment, and merger activity based on uncertainty aversion. Investors must typically decide whether or not to fund an innovative project with very limited knowledge of the odds of success, a situation that is best described as "Knightian uncertainty." We show that uncertainty-averse investors are more optimistic on an innovation if they can also make contemporaneous investments in other innovative ventures. This means that uncertainty aversion makes investment in innovative projects strategic complements, which results in innovation waves. We also show that innovation waves may be sparked by favorable technological shocks in one sector, and then spill over to other contiguous sectors. Thus, innovation waves ripple through the economy amid strong investor sentiment. Finally, we argue that an active M&A market promotes innovative activity and leads to greater innovation rates and firm valuations.
Keywords: ambiguity aversion; hot IPO markets; innovation
JEL Codes: G31; G32; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| availability of diverse investment opportunities (G11) | investor sentiment (G41) |
| investor sentiment (G41) | innovation waves (O36) |
| initial innovation in one firm (O31) | innovation decisions of others (O36) |
| active M&A markets (G34) | innovative activities (O35) |
| innovative firms merging (O36) | enhanced innovation (O36) |
| investor sentiment (G41) | market valuations (G19) |
| innovation rates (O39) | firm valuations (G32) |