Dynamic investment strategies and leadership in product innovation

We study the inter-temporally optimal innovation strategies of incumbent manufacturing firms that compete in an established market and can extend their product line through product innovation. Firms invest in production capacity and R&D knowledge stock, where the R&D knowledge stock and the current R&D investment determine the hazard rate of innovation. Our findings show that the firms’ optimal R&D strategies are driven by a subtle interplay between the relative positions of their R&D knowledge stocks and their current relative positions on the established market. First, we find that under symmetric investment costs the knowledge leader should spend more on R&D than the knowledge laggard only if it has a substantially smaller market share on the established market. If the knowledge leader's market share is sufficiently large, its optimal investment in R&D is so small that its innovation rate is lower than the knowledge laggard's. Second, optimal investment in R&D knowledge is negatively affected by the opponent's production capacity on the established market if the competitor has not innovated yet. However, we find that this effect is reversed after the competitor has successfully introduced the new product on the submarket. Third, the manufacturing firm with higher costs of adjusting production capacity for the established product has a higher incentive to engage in product innovation and might even achieve a higher total discounted profit than its more efficient competitor.