Simultaneous Choice of Process and Product Innovation

This paper investigates the strategic decisions of two identical duopolists, who choose production technology as well as product differentiation through their R&D investment. The product market is characterized by heterogeneous Cournot competition. Firms have an incentive to invest in both process innovation and product innovation. The optimal division between these two kinds of R&D activities changes with market size. The higher consumers' willingness to pay, the more firms' investment is driven to product differentiation. If firms coordinate their R&D activities and share R&D costs, but remain rivals in the product market, they will reduce costs and differentiate their products more than under competition. The optimal proportion of R&D investment is driven more to product innovation than under R&D competition. It can be shown that welfare is increased if firms coordinate their research activities and share R&D costs. When firms cooperate, but do not share their R&D costs, welfare is only enhanced if product innovations are not too expensive.