The Determinants of Firm R&d Investment: a Revisit to Tobin's Q Theory with Product-market Competition Assumption

Abstract: Recently, the link between the traditional Tobin’s Q theory and research and development (R&D) investment has been explored by several studies. In a way to contribute to this emerging literature, our paper focuses on two issues in applying Tobin’s Q theory: the assumption of perfect market competition and the measure of Tobin’s Q. We argue that the former might not be hold, as it overlooks the relationship between market power and innovation that dates back to Schumpeter (1942). With respect to the latter, we propose using the difference in the lagged value of Tobin’s Q, instead of its level in order to capture the expectations of the firm managers about future growth opportunities. Utilizing the generalized method of moments (GMM) estimation on a dataset of 3,985 manufacturing firms from 15 OECD countries over the 2005-2013 period, we report several findings. First, we show that the difference in lagged value of Tobin’s Q has significant and positive effect on firm R&D investment. Second, we report that the relationship between R&D investment and product-market competition is non-linear: R&D investment increases as competition increases from a low level and then decreases as competition exceeds a critical threshold. These findings suggest that Tobin’s Q is a significant predictor of R&D investment but does not reflect all information that the firm takes into account in its investment decisions. Therefore, we call for an augmented Tobin’s Q model, in which market power is considered as a source of rents not captured in the stock-market valuation of the firm.