R&D Investments in the Presence of Free-Riding and Risk-Shifting Incentives: Can Debt Financing Mitigate Under-Investment?

When information is a public good, in equilibrium firms under-invest (relative to the social optimum) in acquiring it, in an attempt to free-ride on investments of other firms. When firms are financed by debt, in equilibrium equity holders invest in riskier projects, relative to the firm-optimal. The interactions between these two inefficiencies arise when risky investments are needed to acquire information that becomes a public good, e.g., as in some RD a demonstration of the value of commitment in a multi-stage game; and reflections on the importance of accounting for debt financing in predicting the effects of subsidies on R&D investments.