Product Innovation With Partial Capacity Rollover

Abstract

This paper analyzes how the transferability of production capacities from an established to a new product influences the incentives of a firm to invest in R&D. A dynamic duopoly model is considered, where initially both firms offer a homogeneous product. The firms invest in production capacities and simultaneously in R&D which determines their innovation rate. The firm that innovates first extends its product line and obtains a patent for the new product that prevents the other firm from catching up. Upon the launch of the new product, the innovator then has the option to transfer part of the capacity for the established product to the production process of the new product. If capacities can be rolled over to the new product, a trade-off can be detected in that this rollover option gives the larger firm more incentive to innovate, whereas the cannibalization effect gives the smaller firm a higher innovation incentive. As a logical consequence we find that the larger firm is expected to innovate first when the capacity transfer does not involve a too high capacity loss. However, if the losses of capacity transfer are considerable, the cannibalization effect starts to dominate and the smaller firm’s incentive to innovate is larger.

Keywords: dynamic duopoly, product innovation, capital accumulation, differential games, Markov perfect equilibrium, capacity rollover