If firms are in a race to introduce some new product or process and if it is important to come first in this race because of the competitive advantage thus conferred, policy-makers often seek to design measures that would give a strategic advantage to `national champions' in their country. In Discussion Paper No. 276, John Beath, Yannis Katsoulacos and Research Fellow David Ulph consider public policies directed towards R&D in the context of a model of two firms engaged in a patent race. Both firms may be engaged in production that yields current profits; one of the firms, possibly as the outcome of some previous race, may already have a competitive advantage over its rival lower marginal costs. Each firm has to decide how much R&D effort to undertake at each instant of time, and for simplicity it is assumed that the probability a firm will discover the new product or process depends solely on the flow rate of R&D expenditure by that firm, not on its accumulated R&D; i.e. there is no learning-by-doing.
The authors derive an expression for the expected present value of each firm's profits as a function of its own and its rival's effort levels and use that to obtain its reaction function, that is its profit-maximizing choice of R&D in response to any given choice by its rival. They find that the R&D behaviour of the two firms is completely determined by two forces. The first is the profit incentive the desire to increase profits by introducing a better production process; this exists even in the absence of rivals, and depends on the difference between the firm's current profits and its profits if it were the only firm to introduce the innovation. The second force is the competitive threat, the pressure to invest in R&D simply to stop rivals gaining competitive advantage. This depends on the difference between the firm's profits if it innovates first and its profits if one of its rivals innovates first. Since one firm may initially enjoy a competitive advantage the absolute and relative magnitudes of these two forces will differ across firms.

The authors argue that most existing analyses of strategic innovation make assumptions that limit the role that one or the other of these forces play, and so can be viewed as special cases of the general framework presented in this Discussion Paper. The size of these two forces for each firm in an industry has important implications for public policy. Suppose one government subsidizes the R&D effort of the firm located in its country. That firm's R&D will increase, but the welfare implications will depend on how this affects its rival's R&D spending and how this, in turn, affects the first firm's profits. If, for example, the rival's competitive threat exceeds its profit incentive, then its response will be to increase its own R&D spending. Now if, for the first firm, the competitive threat also exceeds its profit incentive, the present value of its future profits will fall as the rival increases its R&D expenditure the subsidy will be welfare-reducing. The only circumstances in which the subsidizing country gains, Ulph and his co-authors find, is when the relative magnitudes of the profit incentive and competitive threat are different for the two firms.
The authors also consider policies to encourage cooperative R&D ventures (but which allow competition in the product market after innovation). In the case of a duopoly, such cooperation will reduce the costs of R&D and so tend to increase the amount of R&D, because of the profit motive. Cooperative ventures remove the competitive threat, however, which tends to reduce R&D; and since both firms obtain the innovation, subsequent market innovation will be more intense, reducing the profit incentive. Under some assumptions the second and third effects dominate and cooperative ventures reduce R&D, but this may not generally be true.
Beath, Katsoulacos and Ulph also examine the benefits from cooperation among a sub-group of firms facing competition from a rival group. In this case cooperation only removes the competitive threat between the firms undertaking cooperation they still face a competitive threat from their rivals. These rivals, however, face a greater competitive threat because of the more intense competition that will prevail if the cooperating firms innovate first. All firms end up doing more R&D as a result. The authors give an example where the gains from cooperation are extremely small suggesting that there must clearly be cases where it does not pay

Strategic R&D Policy
John Beath, Yannis Katsoulacos and David Ulph

Discussion Paper No. 276, October 1988 (AM)