Why demand uncertainty curbs investment: Evidence from a panel of Italian manufacturing firms

Theoretically, the effect on investment of uncertainty over the demand for a firm's product is unclear because of the influence of several factors, such as the production technology and the amount of competition in the product market. It has not been possible, until now, to investigate more closely the interplay of different factors in the time dimension because the empirical research has been based on cross-section analysis. This omission makes biased estimates of the investment-uncertainty relationship likely. The aim of this paper is to extend the findings of the empirical literature using a panel of Italian firms in the period 1996-2004, covering a complete business cycle. The availability of panel survey data on companies' investment plans, expected future sales and demand uncertainty allows us to account for unobservable individual differences between firms, macroeconomic shocks and the evolution of the investment-uncertainty relationship. A key finding of our paper concerns the role of the competition encountered by Italian firms in 1996-2004. The gradual loss of market power over time of Italian manufacturing firms, along with the increasing flexibility of labour input has weakened the negative effect of uncertainty on investment decisions. We show that, in repeated cross-section estimates, the omission of firm-specific effects together with the dynamic interplay described above, would have lead to misleading conclusions about the relevance of demand uncertainty in explaining investment decisions.