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We show that the standard analysis of vertical relationships transposes directly to investment dynamics. Thus, when a firm undertaking a project requires an outside supplier (e.g., an equipment manufacturer) to provide it with a discrete input to serve a growing but uncertain demand, and if the supplier has market power, investment occurs too late from an industry standpoint.The distortion in firm decisions is characterized by a Lerner-type index. Despite the underlying investment option, greater volatility can result in a lower value for both firms. We examine several contractual alternatives to induce efficient timing, a novel vertical restraint being for the upstream to sell a call option on the input. We also extend the model to allow for downstream duopoly.When downstream firms are engaged in a preemption race, the upstream firm sells the input to the first investor at a discount such that the race to preempt exactly offsets the vertical distortion, and this leader invests at the optimal time. These results are illustrated with a case study drawn from the pharmaceutical industry.

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We draw from documented characteristics of the biopharmaceutical industry to construct a model where two firms can choose to outsource R&D to an external unit, and/or engage in internal R&D, before competing in a final market. We investigate the tension between outsourced and internal operations, the distribution of profits among market participants, and the incentives to coordinate outsourcing activities, or to integrate R&D and production. Consistent with the empirical evidence, we find that: (1) each firm's internal R&D activity is monotonic in the technology received from the external unit, and the sign of the relationship does not depend on the technology received or generated by the competitor; (2) a measure of direct and indirect technological externalities drives the distribution of industry profits, with lower returns to an external unit involved in research (drug discovery) than in development (clinical trials); (3) upstream entry is stimulated by the long-term perspective for the external unit's owners to earn a larger share of industry profits by selling out assets to a client firm than by running operations. However, in the case of early-stage research, the delinkage of investment incentives from industry value, and the vulnerability of investors' returns to negative shocks, both suggest the abandonment of projects with economic and medical value as a likely consequence of R&D outsourcing.