Cost Pass Through: An Impediment to Innovation?
32 Pages Posted: 23 Aug 2013
Date Written: June 1, 2012
This paper investigates a model of endogenous innovation which results in product diﬀerentiation. Prior to innovation the ﬁrms supplied an entirely homogeneous product. Unlike other models of product diﬀerentiation, the cost of innovation is passed on to consumers in the form of increased prices. However, some consumers do not immediately recognize the innovation and/or its beneﬁts. Such consumers express an unwillingness to pay for this innovation by purchasing from a ﬁrm who does not innovate. A portion of this same fraction of consumers eventually realize the innovation and resume purchases with the innovative ﬁrm with an acceptance of the higher price. Under reasonably broad conditions it is shown that both the innovator’s and the non-innovator’s proﬁts will increase after innovation. Despite the friction created by switching consumers, continued innovation on the part of the ﬁrst ﬁrm to innovate is optimal.
Keywords: Innovation, Product diﬀerentiation, Competition, Cost-Pass-Through, First-Mover-Advantage
JEL Classification: L13
Suggested Citation: Suggested Citation