Multi-Stage Innovations: The Value of Flexibility in a Strategic Setting

Abstract

We consider a quantity-setting duopoly model with both firms having the possibility to produce a homogeneous product. Firm 1 has the option to carry out a product innovation project in two stages and in between the two stages Firm 2 can invest in cost-reducing process innovation. Hence, Firm 1's incentive to complete the innovation of the horizontally and vertically differentiated new product is influenced by Firm 2's process innovation activities.

Our results are as follows. First, we find that under weak vertical differentiation Firm 2 wants Firm 1 to innovate. Horizontal differentiation softens competition and Firm 2 over-invests in process innovation to induce Firm 1 to launch the new product. Second, under strong vertical differentiation Firm 1 starts the product innovation project - triggering under-investment by Firm 2 - but never finishes it. The under-investment leads to higher production costs for Firm 2, which induces Firm 1 not to innovate. Third, under very strong vertical differentiation Firm 2 prevents a launch of the new product by overinvesting in process innovation. Due to the strong decrease in production costs Firm 2 captures such a big market share that Firm 1 will not introduce the new product. However, since its situation in the old market also has become worse, Firm 1's value of the option to innovate is negative.

Keywords: product and process innovation, multi-stage decision making, market introduction, innovation incentives

JEL Classification: L13, O31