Empirical evidence indicates that firms usually have a portfolio of research and development (R&D) projects, some targeted more at process innovations, some at product innovations. The management literature, for example, mentions ratios like 60:40 of total R&D budget for process relative to product innovation in Japanese firms. The fact that Japanese firms invest more in process innovations, while western firms concentrate more on product innovations, is frequently discussed. As possible reasons for differing innovation strategies, cultural distinctions as well as differences in firm size are specified. In the game theoretic model presented in this paper, two other possible explanations will be presented. It turns out that the magnitude of potential market demand, as well as strategic considerations, also influences firms' innovation strategies.

In Discussion Paper No. 1321, Research Affiliate Stephanie Rosenkranz 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 characterised 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.