Research Policy 38 (2009) 1388–1395

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Research Policy
journal homepage: www.elsevier.com/locate/respol

Innovative R&D and optimal investment under uncertainty in high-tech

industries: An implication for emerging economies
Yingyi Tsai a,∗ , Justin Yifu Lin b , Lucia Kurekova c
a
Department of Applied Economics, National University of Kaohsiung, 700 Kaohsiung University Road, Nan-Tze 811,
Kaohsiung, Taiwan
b
The World Bank, 1818 H Street, NW, MSN MC 4-404, Washington, DC 20433, USA
c
Department of International Relations and European Studies, Central European University, Budapest, Hungary

a r t i c l e i n f o a b s t r a c t

Article history: In order to continue on the path to convergence with advanced countries, emerging countries need to
Received 4 October 2007 strengthen their research capabilities. Often they try to do this through the development of strategic
Received in revised form 22 June 2009 industries. The objective of this paper is to contribute to the debate on the effectiveness of policies aimed
Accepted 23 June 2009
at the development of strategic industries in emerging economies. The paper develops a three-phase
Available online 31 July 2009
model for product innovation with capital investment under uncertainty to study the investment deci-
sions of a manufacturer in an industry facing a volatile market demand for new inventions. The findings
JEL classification:
demonstrate the importance of interactions between market structure, a firm’s market power and the
D24
D40
associated cost of adjustment. The paper draws out implications for emerging economies with regard
D81 to policies striving to develop strategic industries in sectors such as semiconductors and information
D92 technology.
E22 © 2009 Elsevier B.V. All rights reserved.
F23
L23
O30

Keywords:
R&D
Capital investment
Uncertainty
High-tech industry
Emerging economies

1. Introduction other neighbouring countries, including India, South Korea and

In order to continue the path of convergence with the advanced
countries, it is essential for the emerging economies to strengthen
their own research capability. In fact, a country’s ability to develop,
adapt and harness its innovative capacity is critical for its eco-
nomic performance in the long run (Ernst, 2005; Ernst and
Naughton, 2005). Casual observations on the recent rapid growth
of developing and emerging economies suggest, for example, that
producers in China have matched their East Asian counterparts,
both in manufacturing and in some key segments of the elec-
tronics and microcomputer industries1 ; and that producers in
∗ Corresponding author. Tel.: +886 7 591 9189; fax: +886 7 216 9365.
E-mail addresses: yytsai@nuk.edu.tw (Y. Tsai), justinlin@worldbank.org (J.Y. Lin),
kurekova lucia@phd.ceu.hu (L. Kurekova).
1 2
Girma et al. (2008) attribute these developments to technological progress,
which is driven by increasing inward direct foreign investment (FDI) in China.
Taiwan, have been striving to secure their positions in the global
value chain2 by forging close partnerships with major global cor-
porations in establishing regional R&D centres for collaborative
works.
But what enables some countries to outperform others while at
the same time fostering technological innovation is perceived to be
an important element in policies on sustainable development. Why
do the majority of emerging economies continue to cater primarily
for the assembly of end products, with some gradually becom-
ing the hubs of research and innovation (Yoffie, 1993; Henderson,
1994; Macher et al., 2007)? It must also be asked whether the rapid
growth in emerging economies, for instance, China, is ephemeral
or whether it is a long-term growth powered by a growing ability
A system of production network consists of vertically linked transnational firms
that are highly specialized and segment-specific (cf. Gereffi, 1995; Caves, 1982).

0048-7333/$ – see front matter © 2009 Elsevier B.V. All rights reserved.
doi:10.1016/j.respol.2009.06.006
 Y. Tsai et al. / Research Policy 38 (2009) 1388–1395
to harness innovation and narrow the technological gap between
them and the industrialized countries.3
The primary objective of this paper is to contribute to the
debate on policy recommendation for the development of strate-
gic industries in some developing and emerging economies. We
use the production of microprocessor units (MPUs) in the semi-
conductor industry as an example to illustrate the main idea of the
paper, i.e., the trade-offs between R&D investment for the accu-
mulation of the stock of knowledge and capital investment for
the accumulation of manufacturing capacity facing a private firm
under uncertainty. We develop a three-period model for product
innovation4 with capital investment under uncertainty to study the
investment decisions of a representative integrated device man-
ufacturer in the semiconductor industry facing a volatile market
demand for new inventions. Our findings demonstrate the deci-
sive impact of the interactions between market structure, a private
firm’s market power, and the share of variable input on a pri-
vate firm’s investments in R&D and capacity under uncertainty.
We specifically show, in an inter-temporal setting, that a positive
R&D investment–uncertainty relationship holds when the stock of
knowledge exhibits diminishing returns, and that a positive capital
investment–uncertainty relationship is weakened with a decrease
in the share of variable input.
Two important developments in the modern world economy
justify our explanation for investments in the production of tech-
nology product/commodities in the high-tech industries by an
analogy, that of microprocessor units (MPUs) production in the
semiconductor sector. First, firms across industries both within
and beyond the emerging economies invest not only in produc-
tion capacity but also in invention. The augmentation of innovative
R&D assists in gaining a better understanding of the development
experiences noted in some Asian countries under international
fragmentation. Second, in a volatile market environment, where
there is an increasing demand for novelty, the wave of produc-
tion fragmentation has forced contracted firms in the emerging
and developing countries to constantly and rapidly replace their
outdated technologies (whether product or process innovation)5
and expand their production facility, while buyers in the developed
economies focus on the creation of new product models. Examples
abound. Mattel, a premier toy brand producer, conducts innova-
tive research for developing models for new products, assembling
the procurement from contracting firms in their own factories. And
the leading technological firms in the semiconductor foundry seg-
ment, Taiwan Semiconductor Manufacturing Company Ltd. (NYSE:
TSM) and Semiconductor Manufacturing International Corporation
(NYSE: SMI), continually invest in both the discovery of advanced
wafer production processes to meet the changing demand and the
expansion of production capacity to secure sourcing contracts.6
We acknowledge the important insights provided in recent
empirical studies by, for example, Girma et al. (2008) and Jefferson
et al. (2006) on the issue of firms’ receipt of subsidies and gen-
eral access to finance. These are positively related to innovation in
the developing countries, while Goerg and Strobl (2007) write on a
similar issue concerning the developed countries.
3
The authors thank an anonymous referee for raising this important question as
a prominent example of current policy debate on this issue (cf. Girma et al., 2008).
4
Research investment conducted for the search of new creation with distinct
features.
5
Emphasizing the aspect of technological improvement and its role in the rapid
decline in the price of chips, Aizcorbe and Kortum (2005) investigate the link
between the causes of recent US productivity gains and the rapid growth of semi-
conductor industry.
6
For the updated corporate information reflecting industry movement, see http://
www.tsmc.com/english/a about/a01 profile/a01 profile.htm and http://www.
smics.com/website/enVersion/Technology/overview.htm.
1389
This analytical paper differs, nonetheless, from these empirical
studies in several important ways. First, we emphasize the peculiar
role of the return to scale of knowledge stock. We demonstrate here
that the innovation-augmented marginal revenue product exhibits
diminishing returns in the stock of knowledge, in contrast to the
literature, in which the innovative aspect of investment is virtually
ignored and the marginal revenue product is linearly dependent
on the stock of capital (see, for example, Lucas, 1967; Hartman,
1972; Abel, 1983; Pindyck, 1988). Second, we highlight the role
of production mode and its implications for optimal investment
in a modern world economy characterized by volatile demand for
new invention. The result suggests that an integrated mode of
production involving both capital and R&D investments weakens
the positive investment–uncertainty relationship, compared with
the dis-integrated production mode with segment-specific, single
investment in either capital or R&D (Tsai and Wu, 2009). The issues
of optimal investment can consequently be far better understood by
simply focusing on an important sector that is significant enough to
capture qualitatively the problems facing most firms in the devel-
oping and emerging economies. We also touch on the role best
played by governments in these economies in fostering an industry
that is competitive at the level of global, or at least regional, econ-
omy. These are important issues within the broader value-chain
context, where most global corporations based in the developed
countries retain at home the production segment exhibiting high
added value, that is, development of new products and/or new pro-
duction technology, at the same time outsourcing the basic segment
of manufacturing to contractors in the developing and emerging
economies (Grieco, 1985; Brown and Linden, 2005; Macher et al.,
2007).
The remainder of the paper is organized as follows. Section 2
provides a background overview of the global semiconductor indus-
try, with particular reference to the production process and recent
structural changes. Section 3 develops a basic model for innovative
R&D and optimal capital investment under uncertainty with asym-
metric finite durability of capital and knowledge stock. Section 4
presents the main result of the investment–uncertainty relation-
ship for both innovative R&D and capacity installation. Section 5
discusses the results and Section 6 concludes.
2. Background to the semiconductor industry
The semiconductor industry is a sector in which rapid techno-
logical progress and market volatility impact significantly on firm
behaviour. One of the booming industries of recent decades, it
is organized within the system of global value chains, where all
the identified stages require both high initial capital and exten-
sive continuing investment if it is to keep up with cutting-edge
developments in the world economy. The fact that the accelerated
technological changes in the production of semiconductors, partic-
ularly microprocessor units (MPUs), has driven the recent increased
productivity growth in the US economy suggests that the sector
could be of crucial importance in attaining sustainable growth
(Jorgenson, 2001) and technological leap (Aizcorbe and Kortum,
2005).
The semiconductor industry has become dominated by large
flagship firms, accompanied by new start-ups that continue to
emerge. Most start-ups are the bearers of new technological know-
how, while large integrated flagship firms tend to dominate the
more established fields of innovation and production. The start-ups,
when prosperous, grow and develop into large firms and gradually
strengthen their position in the international division of knowl-
edge production (Almeida and Kogut, 1997). Rapid changes in,
for instance, the MPUs market highlight the opposing impacts of
product quality and quantity on its prices. While product qual-
ity relies on a firm’s capacity for generating new functions or
1390 Y. Tsai et al. / Research Policy 38 (2009) 1388–1395
Fig. 1. Cyclicality and volatility of the global semiconductor industry. Source: World
Semiconductor Trade Statistics (WSTS).
Fig. 2. Worldwide semiconductor capital spending by region. Source: Gartner
Dataquest, Inc. Data on the amount of worldwide semiconductor capital spending
by regions were obtained from http://www.gartnerdataquest.com.
product features, total quantity in the market is subject to its
production capacity (Semiconductor Industry Association, 2006).
Consequently, a hierarchy of semiconductor products seems to
coexist on the market at any given time, even in the presence of
the sharp declines in the prices of MPU chips over their product
life, as indicated by Moore’s Law (Aizcorbe and Kortum, 2005).
Figs. 1–3 demonstrate the above observations empirically (cf.
Lin and Tsai, 2007).
Fig. 1 demonstrates the contribution of the semiconductor sec-
tor to the global economy and its evolution since 1990. Two
important messages emerge. First, the growth in the global semi-
conductor sector significantly surpassed that of the global GDP
in the period 1990–1995. Second, changes in its revenue growth
suggest that the semiconductor industry is a highly volatile tech-
nological sector.
Fig. 2 shows the capital spending in the global semiconduc-
tor industry according to geographical location. It is evident that
both the North American and the Asian Pacific firms have been
constantly investing in capital since 1996.
Figs. 1 and 2 demonstrate that world revenue growth in 2001
dropped to an all-time low, in spite of the record high global capital
expenditure in 2000.7
Fig. 3 illustrates a complete procedure for the production of
MPUs in terms of production segments. The first two steps of chip
design and its check and tape-out fall into the “product design”
segment, while the remaining steps of wafer processing, sort-
ing, assembly and testing belong to the “manufacture” segment
(Semiconductor Industry Association, 2006).
The semiconductor industry as a whole has been classified as
capital intensive on account of the high software development costs
of design, while wafer fabrication and assembly require massive
fixed capital investment. However, it is to be noted that important
7
Capital spending refers to expenditures in both “capacity building” and “new
invention”. Such information is usually treated as confidential material and it is thus
difficult to draw a fine line between the exact accounts of expenses. Nevertheless,
industry analysts decipher for the estimates by, inter alia, investigating financial
statements, surveying the costs of fixed investment within the industry.
Fig. 3. Complete production procedures of the microprocessor units. Source:
International Technology Road Map for Semiconductors, Semiconductor Industry
Association.
structural shifts have taken place in the industry. The requirements
for human capital intensity vary amongst different production seg-
ments (Brown and Linden, 2005),8 and the share of integrated
device manufacturers (IDMs) in the semiconductor sector that both
design and manufacture components has gradually diminished
under vertical specialization (Ernst, 2005). As a result, the inter-
pretation for the knowledge stock and its accumulation process
depends on the mode of production, and thus differs for the IDMs
and the specialist firms in the semiconductor industry. Indeed, the
knowledge stock of IDMs refers to the capability in new invention
development, which requires huge R&D investment. On the other
hand, the knowledge stock of some specialist firms, such as the
dedicated foundry, may represent its capacity to reduce the produc-
tion cost of a given technology that requires great R&D expenditure,
while the nature of R&D is akin to one of the process innovation.
An immediate implication is that the mode of production can have
a decisive impact on the interpretation for the stock of knowledge
of firms in different segments.
The important messages that emerge imply (i) a waning in-
house interdependence between the design of a product and its
manufacture, and (ii) continued sustaining of the most value-added
design segment in the home country, as well as the off-shoring
of basic production (i.e., manufacturing) segments to areas with
cheaper labour and lower production costs. In spite of the growing
tendency of vertical specialization, the IDMs appear to be the best
fit for delivering the cutting-edge products. In 2004 they were still
generating 85% of the global industry revenue (Macher et al., 2007).
This suggests that the integrated production systems, in which
design and manufacturing segments closely interact and simul-
taneously affect firms’ revenues and costs, remain the prevailing
organizational form in the global semiconductors industry. This in
turn posits that, in the context of investment under uncertainty,
which we model in the next section, the trade-offs that the inte-
grated device manufacturer in the semiconductor industry face are
likely to have implications for all the segments of the production
chain. It also suggests that, if integrated production manufacturers
of high-tech nature are to be home-based in an emerging economy,
it is important to support the investment and growth of promis-
ing enterprises with good access to finance, whether in the form of
private loans or public subsidies.
Having established the characteristics of the semiconductor
industry, we now present a simple model of optimal capital invest-
ment under uncertainty with product innovation.
3. The basic model
Consider the production of a private risk-neutral firm’s end prod-
uct involving investments in both innovative R&D and capacity
building. In the presence of uncertainty, an inverse demand func-
8
A typical chip assembly employs 1000 or more workers of whom around 80%
tend to be low-skilled suggesting that the last part of the value chain is labor intensive
(Brown and Linden, 2005: 283; Silver, 2003: 104).
 Y. Tsai et al. / Research Policy 38 (2009) 1388–1395
tion facing the firm is given by9 :

pt = Xt At yt (1−ε)/ε , (1)
where A represents commodity-specific features and y is total out-
put. The parameter  (0 ≤  < 1) denotes the mark-up coefficient of
A, and ε (≥1) a market structure parameter that takes the value of
1 under perfect competition. The independent random variable X
captures demand uncertainty and follows a subjective probability
distribution of ln Xt = N(ln X̄, t2 ), where X̄ and  t denote mean and
standard deviation respectively.
Eq. (1) captures the opposing forces on price of quality and quan-
tity. The positive effect on price of quality on account of “product
innovation”10 is evident if we interpret A as the outcome of knowl-
edge stock accumulated through research investment Rt at period
t,11 i.e.:
At = Rt + (1 − )At−1 , (2)
where  ∈ (0,1] denotes a constant destruction rate of knowledge
stock.
Eqs. (1) and (2) imply a setting that captures uncertainty in the
demand for new invention, and allows for a separation treatment
in distinguishing demand uncertainty from knowledge accumula-
tion uncertainty. In fact, an emphasis on the ‘technological’ aspect
of uncertainty in R&D activities would imply a stochastic pro-
cess of accumulation in knowledge stock for new invention. This
alternative setting not only de-generates the insights that could
be obtained from an analysis with quantity–quality separation
treatment but also leads to analytical complexity, because the
co-variance between demand uncertainty and R&D uncertainty
emerges.12
It is worth noting that a stochastic Wiener process13 reflecting
uncertainty in the continuous-time setting can deliver interest-
ing insights if we emphasize in the continuous-time setting the
intrinsic uncertain nature of R&D investment for the accumula-
tion of stock of knowledge. Nevertheless, we have considered in
the present analysis an independent random variable which cap-
tures demand uncertainty and follows normal distribution in a
discrete-time setting to avoid analytical complexity while retaining
the qualitative aspect of our results.14
The actual production of final output follows a linearly homoge-
neous Cobb–Douglas technology, i.e., yt = Vt˛ Kt1−˛ , where ˛ ∈ (0,1)
denotes the share of variable input, Vt , and Kt the in-house produc-
tion capacity. To emphasize the link between current investment
and uncertainty, we assume that the firm does not know the state
of market demand until its actual realization at the beginning of
period t, that the horizon is three periods (t = 0, 1, 2), and that cap-
ital stock, Kt , is accumulated by capital investment exhibiting an
9
A deterministic demand function without product-specific features can be found
in Singh and Vives (1984), who derive such a demand from solving a standard utility
maximization problem. In a formulation of stochastic demand without commodity-
specific features similar to Abel (1983), Pindyck (1993) and Abel and Eberly (1997),
Tsai and Wu (2006) study the choices of production mode by a brand-producer and
its impact on investment–uncertainty relationship.
10
See Levhari and Peles (1973) for a justification.
11
For analytical simplicity, we assume away R&D uncertainty and a higher R&D
investment unambiguously leads to greater knowledge stock, which, in turn, gener-
ates higher profit, provided that the destruction rate is not too high.
12
This invariably involves further consideration of the shape of distribution for
both random variables X and A, which, in turn, depend on the mean and variance of
the population of the variable to which the distribution refers (cf. Gujarati, 1995).
13
It represents Brownian motion and is an extension to continuous time of the
discrete time idea of random walk. For detailed discussions and mathematical back-
ground materials, see Dixit and Pindyck (1994).
14
The authors thank an anonymous referee for highlighting the importance of
clarification on the source of uncertainty and its role in our analysis.
1391
Fig. 4. Investment time line for R&D and capital.
overlapping nature, namely15
Kt = It−1 + It−2 , (3)
where It is the amount of capital investment conducted at period t.
Eq. (3) implies, at any time t, that It−1 and It+1 do not exist concur-
rently, but are linked via It , as Kt+1 = It + It−1 and Kt+2 = It+1 + It .
The timing of investment decisions is as follows. At t = 0, the firm
chooses the amount of initial capital investment I0 .16 Later at t = 1,
the firm decides on investments in both production capacity, I1 ,
and innovative R&D, R1 . Finally, at t = 2, the actual market demand
is realized with both knowledge stock A2 and capacity K2 in place
for actual production. We summarize the sequence of decisions in
Fig. 4.
We assume, for the sake of simplicity, that the input price of
both R&D and capacity investments is normalized to one, and that,
at time t, the adjustment cost in capital and research investment
is given by ci (et ), where ci (0) = 0, ci (et ) > 0 and ci (et ) > 0, e = I, R
and i = K, A. The convex adjustment cost assumption suggests that
the cost of adjustment will be greater on average the greater the
amount of investment.17
4. Main results
Before presenting the main results of optimal investments in
both capital and research, and their relations with uncertainty, we
first study the firm’s cash flow at each period t. We then investigate
its optimization problem in the presence of uncertainty.
Based on the realized current price and the distribution of
future price, the firm decides the optimal levels of variable input
(e.g. labour employment), innovative R&D and production capac-
ity. It is easy to verify that the optimal variable input is Vt∗ =
  
(˛/wt ε) Xt Kt At ,18 where wt represents the factor price of the vari-
able input. The optimizing choice for variable input implies that
period-t profit is
 
t = hXt Kt At − cK (It ) − cA (Rt ), (4)
˛/(ε−˛)
where h ≡ (1 − ˛/ε)(˛/wt ε) ,  ≡ ε/(ε − ˛),  = (1 − ˛)(ε − ˛),
and  = .
Eq. (4) shows that the value of the firm is now a function of
both capital stock and knowledge stock, in contrast to the linearly
capital-dependent-only result noted by Caballero (1991), Pindyck
(1993) and Lee and Shin (2000). A close examination of Eq. (4) sug-
 
gests that the term hXt Kt At , which represents marginal revenue
product, is a linear function of capital under a market structure
of perfect competition (i.e., ε = 1), and is concave in capital ( < 1)
under imperfect competition (i.e., ε > 1); that it is convex in knowl-
edge stock if  =  > 1 (i.e., ˛ > ε(1 − )), and concave otherwise.
The important suggestion emerging here is that the discounted
15
See Nakamura (2002) for a justification of this treatment.
16
This formulation implies that the knowledge stock that a firm carries, if at all,
does not contribute to actual production at the outset of its lifespan. A legitimate
justification of this formulation would be the case of “start-ups” that commences
with capacity installation.
17
A fairly standard assumption widely documented in the literature. See, for
instance, Abel (1983), Pindyck (1988) and Abel and Eberly (1997).
18
For similar results, see Abel and Eberly (1997), Lee and Shin (2000), and Tsai and
Wu (2005).
1392 Y. Tsai et al. / Research Policy 38 (2009) 1388–1395
expected marginal profit from additional investments may increase
as future demand Xt becomes more uncertain owing to the convex-
ity effect (cf. Lee and Shin, 2000: 669). There is also the suggestion
that the individual impact on capital investment and R&D invest-
ment of demand uncertainty rests on the interplays between
market structure, the share of variable input, and the price mark-up
due to innovative R&D.
In order to explore the specific investment–uncertainty rela-
tionship for both innovative R&D and production capacity, we now
study the firm’s optimization problem. We assume that the firm
operates in complete markets, discounts expected future cash flows
at a constant rate ˇ > 0, and maximizes the expected present value of

its cash flow. For expositional purposes, capital stock Kt and knowl-

edge stock At in Eq. (4) are denoted by ˚(Kt ) and
(At ) respectively. demand of price mark-up and the firm’s market power implied by
In a three-period setting, the firm’s optimization problem is now
given by
 
Max E[(hX0 ˚(K0 ) − c(I0 )) + ˇ(hX1 ˚(K1 )
(A1 ) − c(I1 ) − c(R1 ))
I0 ,I1 ,R1

+ ˇ2 (hX2 ˚(K2 )
(A2 ))], (5)
subject to K1 = I0 + I1 , K2 = I1 , A1 = R1 , and A2 = (1 − )R1 .
Proposition 1 demonstrates the investment–uncertainty rela-
tionship when a private firm undertakes both demand-enhancing
innovative R&D and capital investments with finite durability.
Proposition 1. For any 0 < ˛ < 1, 0 ≤ < 1, and ε ≥ 1,
 
(a) (dI0 /dE[X2 ]) < 0 and (dI1 /dE[X2 ]) > 0 if (˛/(1 − )) < ε, and

(b) (dR1 /dE[X2 ]) > 0.
Proof. See Appendix A. 
An intuitive explanation for the results contained in Proposition
1 lies in the observation that a private risk-neutral firm constantly
faces the trade-off between benefits generating from successful
innovative R&D for new invention (or new product development)
and possible idle capacity subsequent to capital investment in the
presence of uncertainty. Clearly, the firm can best protect its profit
against market volatility by starting with low capacity investment
at time 0, and then adding, at time 1, on the fixed asset invest-
ment, provided that the share of variable input is not too high. A
lower share of variable input implies less room for adjustment in
response to the realization of future price. This suggests that the
existing stock of capital becomes less valuable under uncertainty.
Nevertheless, the optimal choices of investments are determined
through the changes in the optimal mix of capital, knowledge and
variable input. It follows, for given market demand, that a greater
return to scale of the stock of capital and thus a lower return of the
stock of knowledge (which implies a more valuable stock of knowl-
edge) is required to sustain a given marginal revenue product. We
are thus able to establish a negative investment–uncertainty rela-
tionship at time 0 for capacity investment, and positive one at time
1 for both capital investment and R&D investment.
Section 5 comments on some of the important features of the
result, the implications arise for the design of policy aiming at
encouraging R&D, and the possible directions for modification of
the present setting for further research on the subject of innovation
under uncertainty.
5. Discussion
The following are all crucial to our result: the combination
of imperfect competition due to product innovation, a constant-
returns-to-scale (CRS) technology in the manufacture segment of
production, an irreversible, finite capital investment (cf. Pindyck,
1988; Caballero, 1991), the existence of a variable input, and the
returns to scale parameters for the stocks of capital and knowl-
edge. This combination sheds light on investment for product
innovation, thereby enriching the analysis of optimal (capital)
investment under uncertainty. In addition, the inter-temporal
setting of investment allows for in-depth investigation of the inter-
action between variable input and returns to scale parameter
and its role in underpinning the sign of investment–uncertainty
relationships.
We have demonstrated that the return to scale of the stock
of knowledge plays a decisive role in determining the sign
of investment–uncertainty relationship. In the setting of inter-
temporal capital investment with product innovation, the return
to scale of the stock of knowledge reflects the opposing forces on
the level of imperfect competition. Further, except for the presence
of innovative R&D, the basic model maintains the assumption of
constant-returns-to-scale in basic production by the manufactur-
ing segment, as shown in the literature. However, this brings the
capital investment–uncertainty relationship closer to the results in
the literature (e.g. Hartman, 1972; Abel, 1983).
Nevertheless, important issues relating specifically to govern-
ment support for R&D and the question of whether or not the
central ideas in the current setting would hold implications for a
brand-producing start-up deserve further discussion.19 It is noted
that the element of a publicly sponsored R&D can appear in the
marginal revenue product when subsidy geared to encouraging
innovative R&D is introduced in its simplest form. This would be
a rebate per unit investment expenditure in the firm’s total cost of
adjustment,20 even though the present model explicitly considers
only the self-funded R&D of private firms. Hence, the present analy-
sis, however indirectly, holds important implications for the design
of R&D support by the public sector.
It is further noted that, while approximating the optimization
problem of a representative brand-producing firm under demand
uncertainty, the current setting and the main results could hold
implications for a brand-producing start-up when we emphasize
the length of investment period in capacity building for a new
entrant and interpret as the lead time for developing its full-fledged
core competence a longer period of investment in capital than
in R&D. This interpretation for our analytical framework there-
fore facilitates a qualitative representation of the complementarity
between upstream design and downstream manufacturing firms
within the broader context of production fragmentation and/or
vertical specialization.
How would the results obtained in this paper change if we
were to consider an alternative structure in which knowledge
stock required a longer time span than capital to accumulate for
production? Would the results vary for different specifications of
uncertainty? We argue that our findings stand up robustly to mod-
ifications in the nature of production technology with respect to
stock of either capital or knowledge, and that the findings on the
uncertainty–investment relationship remain valid, even if we con-
sider an alternative distribution of the random variable, such as
mean-preserving spread, in the present framework (cf. Lee and
Shin, 2000). Nevertheless, as far as future research is concerned,
it might be interesting to investigate different forms of probabil-
ity distribution that may capture the dynamics of other high-tech
aspects of industry, such as bio-technology, in an alternative but
appropriate manner. This would provide relevant implications for
the development of strategic industry other than semiconductor
and information technology.
19
The authors thank an anonymous referee for pointing out these issues.
20
Other policy instruments include a tax holiday, tax credit and a tax refund.
 Y. Tsai et al. / Research Policy 38 (2009) 1388–1395
6. Conclusions
For the present purpose of theoretical analysis, the representa-
tion of firm value by stocks of both capital and knowledge in the
presence of uncertainty should be sufficiently general to approxi-
mate the actual function in a fairly wide range of practical situations
and yet be specific enough to derive some policy implications from
the theoretical analysis. We summarize below the policy implica-
tions generated by the main result that may be important to the
development of strategic industry in some developing and emerg-
ing countries. We first highlight the role of adjustment cost and its
impact on optimal investments. We then explore the implications
for production advantage of the investment period. Finally, we dis-
cuss the implications for development paths of the return to scale
of stocks of capital and knowledge.
A strictly convex adjustment cost suggests that the average costs
are greater for higher levels of I and R. This implies diseconomies of
scale in production and consequently a restricted firm size, even in
the presence of a linearly homogeneous production technology. In
a broader context of production fragmentation, if we interpret the
commodity features, A, and the total quantity, y, as the segment-
specific output of ‘design’ and ‘manufacture’, then an immediate
policy implication of our result shows the importance of identify-
ing, at firm level, the relative advantage underlying the direction
of growth, and thus the development paths. Furthermore, if we
interpret, from the perspective of capacity building, the length of
investment undertakings as the production advantage on which the
value of a private firm rests, then the present setting implies that
the private firm excels in the ‘manufacturing’ segment and is able
to deliver the end goods while simply following the blueprints pro-
vided by its partner in the context of production networks. Hence,
the qualitative results obtained here continue to hold in an alterna-
tive setting with longer investment period in R&D than in capacity.
This reflects the patterns of investment, and thus growth paths,
as noted in the advanced economies. Finally, a higher return to
scale of the stock of knowledge implies the extent to which price
increase due to commodity-specific features becomes larger. This
suggests that the marginal revenue product rises with the stock
of knowledge as market demand becomes more sensitive to the
commodity features, namely, a higher elasticity of commodity fea-
tures with respect to price. The reasoning applies similarly to the
return to scale of the stock of capital. It follows that the firm would
direct resources away from capital investment should its stock of
knowledge exhibit increasing returns to scale ( > 1 in the present
analysis). At most, the firm could focus solely on the ‘design’ seg-
ment of production.21 Nevertheless, the convex cost of adjustment
implies diseconomies of scale in the accumulation of capital stock
and knowledge stock. Our result therefore highlights the peculiar
role of the return to scale in directing the paths of development, be
it the specific segment at industry level or a particular industry at
(A1 ) − c  (I0 ), (A.1)
the level of national economy.
(A1 ) + ˇ2 hE[X2 ]˚ (K2 )
(A2 ) − c  (I1 ), (A.2)
Overall, the results of this paper provide important insights into
the debate on whether or not to support the development of certain
 (A1 ) + ˇ2 hE[X2 ]˚(K2 )
 (A2 )−c  (R1 ). (A.3)
high-tech industries, and, if so, to decide which of them deserve
more active assistance than others in the public sector. In fact, if
(At ) = At and ˚(Kt ) = Kt , the first derivatives are given by
we interpret the returns to scale (be it in knowledge or capital
stock) as a characterization of comparative advantage underlying
(A1 )
a private firm’s production (e.g. Lin and Tsai, 2004), then our result
 (A1 ) ≡ = (R1 )−1 ,
implies that the nature of investment and the associated cost of
adjustment, as well as industry-specific characteristics and market
structure ought to be duly understood before the public sector can
21
This is, indeed, justified by current observations in the semiconductor industry
where the ‘fabless’ firm is experiencing an unprecedented growth (Macher et al.,
2007; Brown and Linden, 2005).
1393
commit itself to the development of certain high-tech industry like
semiconductor and information technology.
Our findings also suggest that, should the participation of public
funding in R&D be inevitable in the context of “non-globalization
of innovation” (Macher et al., 2007: 9–10), then the nature of
investment should be carefully studied before the actual support
(or policy instrument) can be formally introduced. This can be
understood from a modification of our model into another one
with overlapping R&D investment, instead of capacity investment,
implying a continuing investment flow for new invention. In fact,
in a market environment with rapid technological progress and
volatile demand, issues of distortion deserve greater attention in
both the developing and emerging economies on account of the
scarcity of financing resources for the development of technologi-
cal expertise. This is despite government policies being unilaterally
introduced in support of its growth in the domestic economy.
Acknowledgements
This paper was substantially revised when the first and third
writers visited the Development Studies Committee, Cambridge
University. Both authors are appreciative of the hospitality and
impressive facilities offered during their visit. They appreciate also
the valuable comments by participants at the 2007 Cambridge
Advanced Programme for Rethinking Development Economics
(CAPORDE), and those at the Inaugural All China Economics Inter-
national Conference at the City University of Hong Kong. The
corresponding author thanks Wei-Chung Wang for helpful discus-
sions. The views expressed here are those of the second author, not
his institution. Any errors are the writer’s own.
Appendix A.
Before we formally prove the results contained in Proposition
1, it is important to note that, if ln X is normally distributed,

then E[X] = exp{E[X] + 1/2 var[X]}. Using Eq. (5), we have E[Xt ] =
   2 
exp{E[Xt ] + 1/2 var[Xt ]} = X̄t exp{( − 1)t /2}. Since E[Xt ] is
strictly increasing in  t , it follows that the sign of dIs /d t and dRs /d t
 
is the same as that of dIs /dE[Xt ] and dRs /dE[Xt ], respectively. The
proof of the main result contained in Proposition 1 is organized in
two steps as follows. We first investigate the first-order conditions
for a regular maximum, then, assuming that the second-order con-
ditions hold, we calculate the comparative statistics to the system
of Eqs. (A.1)–(A.3).
Step 1. Denote by f(I0 , I1 , R1 ) the objective function of the
maximization problem characterized by Eq. (5). The first-order con-
ditions are given by fI0 = 0, fI1 = 0, and fR1 = 0, respectively. More
precisely,
 
fI0 = hE[X0 ]˚ (K0 ) + ˇhE[X1 ]˚ (K1 )
 
fI1 = ˇhE[X1 ]˚ (K1 )
 
fR1 = ˇhE[X1 ]˚(K1 )

Using
∂
∂R0
∂˚(K1 )
˚ (K1 ) ≡ = (I0 + I1 )−1 , and
∂I0
∂˚(K2 )
˚ (K2 ) ≡ = (I0 )−1 ,
∂I1
respectively.
1394 Y. Tsai et al. / Research Policy 38 (2009) 1388–1395

 
The second derivatives of
(At ) and ˚(Kt ) are given, respectively, dfI1 = dfI1 (E[X1 ], E[X2 ], I0 , I1 , R1 )
by  
= C dE[X1 ] + D dE[X2 ] + a21 dI0 + a22 dI1 + a23 dR1 = 0, (A.8)
∂2
(A1 )

 (A1 ) ≡ = ( − 1)(R1 )−2 ,

∂R0 ∂R0
 
dfR1 = dfR1 (E[X1 ], E[X2 ], I0 , I1 , R1 )
∂2 ˚(K1 )  
= E dE[X1 ] + F dE[X2 ] + a31 dI0 + a32 dI1 + a33 dR1 = 0,
˚ (K1 ) ≡ = ( − 1)(I0 + I1 )−2 , and (A.9)
∂I0 ∂I0
where

∂2 ˚(K2 ) C = ˇh˚ (K1 )

(A1 ), D = ˇ2 h˚ (K2 )
(A2 ),
˚ (K2 ) ≡ = ( − 1)(I0 )−2 ,
∂I1 ∂I1
E = ˇh˚(K1 )
 (A1 ), and F = ˇ2 h˚(K2 )
 (A2 ).
respectively.
The Jacobian of f(I0 , I1 , R1 ) is denoted by
Writing Eqs. (A.7)–(A.9) in a matrix form, we have
    ⎡ ⎤⎡ ⎤ ⎡ ⎤
a11 a12 a13 fI0 I0 fI0 R0 fI0 R1  
a11 a12 a13 dI0 A dE[X0 ] + B dE[X1 ]
J= a21 a22 a23 = fR0 I0 fR0 R0 fR0 R1 ,
⎢ ⎥⎢ ⎥ ⎢   ⎥
a31 a32 a33 fR0 I1 fR1 R0 fR1 R1 ⎣ a21 a22 a23 ⎦ ⎣ dI1 ⎦ = − ⎣ C dE[X1 ] + D dE[X2 ] ⎦ . (A.10)
 
a31 a32 a33 dR1 E dE[X1 ] + F dE[X2 ]
where
  Let
a11 = fI0 I0 = hE[X0 ]˚ (K0 ) + ˇhE[X1 ]˚ (K1 )
(A1 ) − c  (I0 ) < 0, ⎡ ⎤
⎡ ⎤ A dE[X0 ] + B dE[X1 ]
 
r1

⎢
⎣ r2 ⎦ = − ⎣ C dE[X1 ] + D dE[X2 ] ⎥
⎦
a12 = fI0 I1 = ˇhE[X1 ]˚ (K1 )
(A1 ) = a21 < 0,
r3  
E dE[X1 ] + F dE[X2 ]
 ⎛⎡ ⎤ ⎡ ⎤ ⎡ ⎤ ⎞
a13 = fI0 R1 = ˇhE[X1 ]˚ (K1 )
 (A1 ) = a31 > 0. A B 0
≡− ⎝ ⎣ 0 ⎦ 
E[X0 ] + ⎣ C ⎦ 
E[X1 ] + ⎣ D ⎦ E[X2 ]⎠ ,

a21 = fI1 I0 = ˇhE[X1 ]˚ (K1 )
(A1 ) = a12 < 0, 0 E F

and  = det(J).
 
a22 = fI1 I1 = ˇhE[X1 ]˚ (K1 )
(A1 ) + ˇ2 hE[X2 ]˚ (K2 )
(A2 ) − c  (I1 ), Applying Cramer’s rule to Eq. (A.10), it is easy (but tedious) to
show that
  dI0 −1
a23 = fI1 R1 = ˇhE[X1 ]˚ (K1 )
 (A1 ) + ˇ2 hE[X2 ]˚ (K2 )
 (A2 ) = a32 .  = [a13 (Da32 − Fa22 ) − a12 (Da33 − Fa23 )], (A.11)
dE[X2 ] 

 dI1 −1
a31 = fR1 I0 = ˇhE[X1 ]˚ (K1 )
 (A1 ) = a13 , = [a11 (Da33 − Fa23 )], and (A.12)

dE[X2 ] 

 
a32 = fR1 I1 = ˇhE[X1 ]˚ (K1 )
 (A1 ) + ˇ2 hE[X2 ]˚ (K2 )
 (A2 ) = a23 , dR1 −1
 = [F(a11 a22 − a12 a21 ) + D(a31 a12 − a32 a11 )]. (A.13)
dE[X2 ] 
 
a33 =fR1 R1 =ˇhE[X1 ]˚(K1 )
 (A1 ) + ˇ2 hE[X2 ]˚(K2 )
 (A2 ) − c  (R1 ). Using Eqs. (A.4)–(A.6), and (A.10), we can now study the impact of

future demand changes (i.e., E[X2 ]) on I0 , I1 , and R1 by investigating
Notice that the first term in a23 (which is essentially identical to a32 )   
the properties of dI0 /dE[X2 ], dI1 /dE[X2 ], and dR1 /dE[X2 ].
equals to a13 . Furthermore, the assumption that the second-order 
(A) We first study the sign of dI0 /dE[X2 ]. Using (A.11), we
conditions holds suggests 
have (dI0 /dE[X2 ]) = (−1/)[a13 (Da32 − Fa22 ) − a12 (Da33 − Fa23 )],
det(a11 ) = a11 < 0, (A.4) where a12 < 0, a13 > 0, and (Da33 − Fa23 ) < 0 if (˛/(1 − )) < ε
  (which is equivalent to 1 − ((ε − 1)/ε) < ((1 − ˛)/ε)). Hence,
 
a a12  for any ˛, , and ε such that (˛/(1 − )) < ε, (dI0 /dE[X2 ]) <

=  11
a11 a12
det > 0, and (A.5)
a21 a22 a21 a22  0 if and only if (Da32 − Fa22 ) < 0. Rewriting (Da32 − Fa22 ) < 0 as

(D/F − 1)a32 < (y − a13 ), where y = ˇhE[X1 ]˚ (K2 )
(A2 ) − c  (I1 ) <
 
 a11 a12 a13  0, it is straightforward to show the negative sign of (y − a13 )
 
det(J) =  a21 a22 a23  < 0. (A.6) since a13 > 0 and y < 0. Furthermore, notice that a32 > 0, it is clear
a a a  that (Da32 − Fa22 ) < 0 cannot hold if (D/F − 1) > 0 (i.e., D > F =
D,
31 32 33
where
=
 (A2 )˚(K2 )/
(A2 )˚ (K2 ),
(A2 ) ≡ (1 − ı) (R1 ) ), and
Step 2. To evaluate the impact of future price changes on I0 , I1 , ˚(K2 ) ≡ (I1 ) ). It follows that (Da32 − Fa22 ) < 0 cannot hold
and R1 , we first consider the total differential of fI0 , fI1 , and fR1 . By if ((1 − ˛)/ε) > ˇ(I1 /R1 ). Further, note that (Da33 − Fa23 ) < 0 if
taking the total differential of fI0 , we have 1 − ((ε − 1)/ε) < ((1 − ˛)/ε). Hence, we have now established that

 
(dI0 /dE[X2 ]) < 0 if 1 − ((ε − 1)/ε) < ((1 − ˛)/ε) ≤ ˇ(I1 /R1 ), or alter-
dfI0 = dfI0 (E[X0 ], E[X1 ], I0 , I1 , R1 ) natively, (˛/(1 − )) < ε.

  (B) We then examine the sign of dI1 /dE[X2 ]. Since
= A dE[X0 ] + B dE[X1 ] + a11 dI0 + a12 dI1 + a13 dR1 = 0, (A.7) 
where A = h˚ (K0 ) and B = ˇh˚ (K1 )
(A1 ).
Similarly, by taking the total differential of fI1 and fR1 , we have
(dI1 /dE[X2 ]) = (−1/)[a11 (Da33 − Fa23 )], and a11 < 0, it is obvious

that sign(dI1 /dE[X2 ]) = sign(Da33 − Fa23 ). Using Eqs. (A.1)–(A.3),
(Da33 − Fa23 ) is given by
 Y. Tsai et al. / Research Policy 38 (2009) 1388–1395 1395


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