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Information externalities, free riding, and optimal exploration in the UK oil industry

May 2019
Working Paper
19-013
By  Charles Hodgson

Information spillovers between firms can reduce the incentive to invest in R&D if Property rights do not prevent firms from free riding on competitors’ innovations. Conversely, strong property right over innovations can impede cumulative research and lead to inefficient duplication of effort. These effects are particularly acute in natural resource exploration, where discoveries are spatially correlated and property rights over neighboring regions are allocated to competing firms. I use data from offshore oil exploration in the UK to quantify the effects of information externalities on the speed and efficiency of exploration by estimating a dynamic structural model of the firm’s exploration problem. Firms drill exploration wells to learn about the spatial distribution of oil and face a trade-off between drilling now and delaying exploration to learn from other firms’ wells. I Show that removing the incentive to free ride brings exploration forward by about 1 year and increases industry surplus by 31%. Allowing perfect information flow between firms raises industry surplus by a further 38%. Counterfactual policy simulations highlight the trade off between discouraging free riding and encouraging cumulative research – stronger property rights over exploration well data increase the rate of exploration, while weaker property tights increase the efficiency and speed of learning but reduce the rate of exploration. Spatial clustering of each firm’s drilling licenses both reduces the incentive to free ride and increases the speed of learning.