Although the existence and magnitude of R&D spillovers has been documented, there is no empirical consensus as to whether R&D spillovers actually lower incentives. This working paper models the strategic interaction between two types of firms: innovating firms that invest in strategic cost-reducing R&D and non-innovating firms - the fringe - competing in a homogeneous product market. The paper examines the situation where new scientific or technological knowledge may involuntarily spill out and be of use in someone else's R&D effort, thus undermining the incentive to innovate. The author suggests that larger spillovers may actually stimulate a firm's cost-reducing R&D effort in industries where innovative capabilities are asymmetrically distributed across rivals and that one relatively unexplored aspect in this area is the role of firm heterogeneity.
In this working paper, Marco Ceccagnoli, Assistant Professor of Strategy and Management at INSEAD, formally analyzes and tests the implications of such an asymmetric market structure in order to better understand the impact of spillovers on the incentive to innovate by extending previous oligopoly models to identical firms, marginal cost-reducing R&D and spillovers. A key finding of the model is that a greater proportion of the market populated by non-innovating firms may stimulate the expansion of innovating firms' output as a result of larger incoming spillovers, thus providing a positive scale effect on innovation incentives, as well as dampening the disincentive effect of larger outgoing spillovers on the output expansion effect of additional cost-reducing R&D. Overall, the results suggest that imitation across innovating rivals may actually stimulate further cost-reducing investments at the expense of non-innovating competitors.
The author also finds that business unit size is endogenous, and that cost-reducing R&D is proportional to business unit size, as predicted by the model - a fact that should be taken into consideration by scholars analyzing the empirical determinants of innovation incentives in the Schumpeterian tradition who have neglected the simultaneity between size and R&D investment decisions. Although several limits are associated with the static theoretical framework presented and the underlying data and measures, this paper explains why the relationship between spillovers and the incentives to innovate is so controversial by finding yet another important neglected conditioning factor, namely the composition of the industry in terms of true innovating firms and the competitive fringe.