Incentives to Innovate in a Cournot Oligopoly

Author(s): Flavio Delbono and Vincenzo Denicolo

Source: The Quarterly Journal of Economics, Vol. 106, No. 3 (Aug., 1991), pp. 951-961
Published by: Oxford University Press
Stable URL: http://www.jstor.org/stable/2937936
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INCENTIVES TO INNOVATE IN A COURNOT OLIGOPOLY*

FLAvio DELBONO AND VINCENZO DENICOLO

I. INTRODUCTION

A classic problem in industrial economics is whether a more

competitive market structure leads to a faster pace of innovations.
Most of the recent game-theoretic analyses of this problem rely
upon the seminal contributions of Loury [1979], Lee and Wilde
[1980], and Dasgupta and Stiglitz [1980].
Lee and Wilde [1980] model a one-shot noncooperative game in
which n identical players invest in R&D with the aim of innovating
first. The firm that innovates first is awarded an exogenously given
prize. The losers of the R&D race get nothing and therefore suffer a
loss given by the R&D cost xi. There is perfect and infinitely lived
patent protection, and no further innovation is anticipated. The
probability of success by firm i is a function of its R&D expenditure
xi; xi is a flow cost that firm i pays until one player succeeds. Lee and
Wilde show that an increase in the number of firms increases the
equilibrium individual R&D effort.' Furthermore, assuming that
the social benefit from the innovation is equal to the prize obtained
by the winner, they prove that in the industry equilibrium each
firm invests more than is socially optimal.
These results depend on a very particular specification of
incentives and payoffs: the prize is exogenously given and indepen-
dent of the number of firms; the losers get nothing; and no account
is taken of the possibility that before the innovation firms make
positive profits. These assumptions may be appropriate in some
contexts.2 However, they seem inappropriate in other contexts: for

*We wish to thank F. Panunzi, the seminar audience at Bologna (ESEM 1988),
and three anonymous referees for detailed criticisms on earlier drafts. Errors and
omissions are ours.
1. Lee and Wilde's [19801 analysis is a reformulation of Loury's [19791 model.
Loury assumes that the R&D cost is a lump sum initial investment, whereas Lee
and Wilde assume a flow investment. Loury finds that an increase in the number of
firms reduces the equilibrium individual R&D effort, but brings about an earlier
expected date of innovation. The intuition behind these conclusions is simple. In the
Loury model an increase in the number of firms reduces the expected benefit to
investment, leaving expected costs unaffected. The firm responds by reducing
investment. In the Lee and Wilde model both expected benefits and expected costs
are reduced by the addition of another firm, and the net effect is to increase
incentives to invest. See Reinganum [1984], p. 62.
2. There are at least three ways to justify these assumptions. The first one is to
assume that the n firms compete in prices in a homogeneous product market under

c 1991 by the President and Fellows of Harvard College and the Massachusetts Institute of
Technology.
The Quarterly Journal of Economics, August 1991

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952 QUARTERLY JOURNAL OF ECONOMICS

instance, in the case of cost-reducing innovations, when firms are

quantity-setting Cournot players in the product market.3 In this
case, the prize to the winner depends on the number of firms; losers
may reap positive profits in the post-innovation equilibrium;4 and
before the innovation firms may make positive profits. Further-
more, the social and private benefits from the innovation differ: the
private benefit is given by the increase in future profits of a single
firm, while the social benefit also includes the change in other
firms' profits and in consumer surplus.
In this note we present a model of a patent race between
Cournot oligopolists which retains the basic framework of Lee and
Wilde, but does not support some of their conclusions. More
precisely, we show that (a) an increase in the number of firms may
result in a decrease in the equilibrium R&D effort of each firm and
in the equilibrium total effort; (b) in equilibrium there may be
underinvestment with respect to the social optimum.
We set out the model in Section II, where we show that Lee and
Wilde's result still holds when the post-innovation market profits
of the winners as well as those of the losers do not depend on the
number of firms. When they do, generally speaking, the effect of an
increase in the number of firms is ambiguous. To obtain more
definite results, we specialize the model in Section III, and we show
that an increase in the degree of rivalry can reduce the equilibrium
R&D effort rate. Section IV contains the welfare analysis of the
market equilibrium.

constant returns to scale, so that a Bertrand equilibrium results. Then, before the
innovation-when they share the same technology-all firms make zero profits,
and after the innovation the winner, which has reduced his own cost, will be the only
active firm. (It should be noticed, however, that under this interpretation n cannot
be taken as a measure of the strength of competition in the product market.)
Second, one can think of an initial position where all firms have such high costs that
it is not profitable for them to enter the market (as in the case when the innovation
creates a new product); thus, only the innovator will be active in the post-innovation
equilibrium. Finally, a third interpretation is that of firms (laboratories) as
producers of know-how that is valuable only to the first succeeding in discovery,
which can patent the innovation and sell it to the final producers.
3. Early attempts to analyze the R&D performance of Cournot oligopolists are
Horowitz [19631 and Scherer [19671.
4. Stewart [1983] too has dropped the assumption that the winner takes all
and has introduced a "share parameter" a which indicates how the prize is split
between the winner (which gets a fraction a of the prize) and the losers (which get
(1 - a)/(n - 1)). Stewart claims that an increase in the number of firms decreases
the equilibrium R&D effort. However, this result depends on a being equal to a
critical value a*, which is a decreasing function of n. It can be shown that, if a is kept
constant, then in Stewart's model an increase in n increases the individual effort, as
in Lee and Wilde [1980]. The negative sign of the derivative found by Stewart
entirely depends on the negative effect that an increase in n has on the incentive to
innovate, via the reduction in the share parameter a*.

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 INCENTIVES TO INNOVATE IN A COURNOT OLIGOPOLY 953

II. BACKGROUND

Lee and Wilde model a one-shot game where the payoff

function of firm i (i = 1, 2, . .. , n) is the present value of expected
profits, net of R&D costs; i.e.,

(1) V, = f e-( h(xi) +r) t[h(x,)W-xi] dt= Wh(x,) -xi

a +h(xi) +r'
where W is the prize accruing to the innovating firm, which is
assumed to be a fixed sum (the same for all firms), xl is i's R&D
expenditure, h(xi) is i's instantaneous probability of innovating,
a = 4i h(xj) is the instantaneous probability that one of the (n - 1)
rivals of firm i innovates, and r is the discount rate. The hazard
function h(x,) is assumed to be strictly concave and to satisfy th
Inada conditions, which guarantee that the maximization problem
will always yield an interior solution, and that the second-order
condition is satisfied.
Using the first-order condition for a maximum for firm i, and
focusing on the symmetric equilibrium of the model, one derives
the following equilibrium condition:

(2) (n - 1)h(x) h'(x)W + h'(x)Wr - r - nh(x) + xh'(x) = 0.

Let x * denote the solution of (2), i.e., the equilibrium R&D effort.
Implicitly differentiating, one gets

Ax* h(x) [Vh'(x) - 1]

an af /0x

where f denotes the left-hand side of equation (2). A stability

condition of the model is that in equilibrium, if all firms increase
their investment rate by the amount dx, the remaining firm must
increase its investment rate by less than dx. It can be shown that
this condition is equivalent to af /0x < O.' Then, the sign of Ax */

5. From expression (2) we get

af= (n - 1)h'(x) [Vh'(x) - 1] + [(n - 1)h(x) + r] Vh"(x) + xh"(x).

ax

On the other hand, the stability condition of the model is (see Lee and Wilde
[1980], p. 432):
adx
1- _ (n - l)h'(x) > 0,

which reduces to

Vh"(x) [(n - 1)h(x) + r] + xh"(x) < -(n - 1)h'(x) [Vh'(x) - 1],

which implies that af lax < 0.

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954 QUARTERLY JOURNAL OF ECONOMICS

is given by the sign of the term inside the square brackets in (3).
From (2) it is clear that [Wh' (x) - 1] is positive, by the concavity of
h. Hence Ax */In is positive. This is Lee and Wilde's result.
Now consider a symmetric Cournot oligopoly with n active
firms. Firms compete in the product market and also compete for a
cost-reducing innovation. We shall analyze the subgame perfect
equilibrium of the two-stage game, where firms compete in R&D in
the first stage and in output levels in the second stage.
We assume that only one innovation is in prospect, which gives
the winner the exclusive right to use a more productive technology
forever. R&D investment affects the expected date of innovation,
but does not affect its nature, nor downstream profits.
Assume that all firms have the same cost before the innovation
and the pre-innovation equilibrium in the product market is
symmetric. The payoff of firm i in the R&D game is given by the
present value of future profits net of R&D costs:

h(xi)'Trr~r + aTrr*/r + Trri - x

r + a + h(xi)

where mr*r is the flow of profits accruing forever to the firm that
innovates first, i.e., the winner of the R&D race, SOL is the flow of
profits accruing forever to the losers, and irr is i's current profit.
In a symmetric equilibrium,6 the following condition must
hold:

(5) (n - 1) (1/r)h(x) h'(x) (4m* - m*L)

+ h'(x) (4r* - mri) - r - nh(x) + xh'(x) = 0.

Equation (5) determines the equilibrium value of the R&D expendi-

ture x *. The two terms that appear in (5) and did not appear in the
first-order condition of the Lee and Wilde model are ('rT* - irT*) and
(irTW - iri). The first one is the difference between the flow of profits
accruing forever to the winner and that accruing to the losers; the
second one is the difference between the profit to the winner and
his current profit. The former (i.e., ('rr* - mr*L)) reflects the presence
of rivalry in the technological competition: each firm anticipates
that, should it fail to innovate, one of its rivals would succeed and

6. It can be shown that the symmetric equilibrium is unique and locally stable
provided that af /ax < 0, where f now denotes the left-hand side of (5): cf. Delbono
and Denicol6 [1990], appendix.

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 INCENTIVES TO INNOVATE IN A COURNOT OLIGOPOLY 955

gain a technological lead. Thus, this effect characterizes situations

of strategic interaction: following Beath et al. [1989], we shall call it
the "competitive threat." The difference (Tr* - iri), on the other
hand, measures the incentive to invest in R&D in the absence of
rivalry, that is the "profit incentive." In the Lee and Wilde model
there are no pre-innovation profits, and the losers get nothing, so
that both incentives collapse into rW. Clearly, in our model the
presence of current profits and the fact that even the losers make
positive profits in the post-innovation equilibrium induce firms to
delay the expected date of innovation.
Notice that, under standard regularity conditions, in a Cournot
equilibrium 4T*, u and Tr, are all decreasing functions of n.
Implicitly differentiating (5), we get

ax *
(6) a~ = h (x *)h'(x *) IT-1W h(x *)h'(x *)I rL

(n -
+ h'(x*) h(x *) an
r an

- h (x*) [r + nh(x*)]-2.
an

There are four terms inside curley brackets on the right-hand side
of (6). The first one represents the "Lee and Wilde effect," and by
the first-order condition is always positive. The second term
reduces the Lee and Wilde effect, taking into account that now even
losers make profits in the post-innovation equilibrium. However, if
this were the only difference with respect to the Lee and Wilde
model, by (5) and the concavity of h it would still follow that
ax*/an > 0.
The third and fourth terms capture the change in the incen-
tives to innovate due to a change in the number of firms and are
crucial to our analysis. Specifically, the third term relates to the
competitive threat, whereas the fourth term relates to the profit
incentive. The sign of these terms is ambiguous, because mr*, I*
and rri are all decreasing functions of n, and generally speaking, on
cannot rank the derivatives of mr*, m*, and 7Ti with respect to n
without further specifications of costs and market demand. This
ambiguity is responsible for the comparative statics result of
Proposition 5 below.
Clearly, if 4r* and iT* do not depend on n, then the sign of the
derivative of the competitive threat with respect to n will vanish,

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956 QUARTERLY JOURNAL OF ECONOMICS

and the derivative of the profit incentive will unambiguously be

positive. Hence we have

PROPOSITION 1. If the profits of the winner and of the losers after

the innovation are independent of n, and if the stability
condition holds, then an increase in the number of firms
increases the equilibrium R&D effort rate of each firm.

Let us define a "drastic" innovation as one that gives the

winner monopoly power; in other words, the post-innovation
monopoly price is lower than losers' production cost. Since post-
innovation profits then do not depend on the number of firms, from
Proposition 1 it follows that

COROLLARY. If the innovation is drastic, then an increase in the

number of firms increases the equilibrium R&D effort rate of
each firm.

However, if the innovation is not drastic, very little can be said,

generally speaking, about the sign of the derivative (6). One may
conjecture that the Lee and Wilde result may fail to hold in some
circumstances. To obtain more definite results, we now turn to a
specialization of the model.

III. A SIMPLE MODEL

In this section we specialize the model set forth in Section II,

assuming a linear market demand function, constant marginal
(and average) production costs, and a specific, well-behaved hazard
function.
There are n identical firms, each producing a homogeneous
good whose market demand function isp = a - Q, where p is price
and Q is total output. Before the innovation, all firms produce at
constant marginal and average cost c, 0 < c < a. Then, in the
unique symmetric Cournot equilibrium, firm i earns profits per
unit of time: 7ri = s2/(n + 1)2, where s = (a - c) is a measure of th
size of the market.
In the first stage of the game, firm i invests in R&D at rate xi,
where xl is the flow cost that firm i pays until someone succeeds.
The probability that firm i be first to innovate at time t, given no
success to date, is h(x,) = 2puV/, where pu > 0 is a parameter
measuring the efficiency of R&D expenditure.
Firms compete for an innovation that gives the winner the

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 INCENTIVES TO INNOVATE IN A COURNOT OLIGOPOLY 957

exclusive right to produce at cost c * < c forever. Since the case

drastic innovation is already covered by the Corollary to Propo
tion 1, we assume that the innovation is nondrastic; in our mod
this means that c * > 2c - a, or s > d, where d = (c - c *) den
the cost improvement. This assumption implies that the losers
the R&D race, while continuing to produce at cost c, will rem
active in the post-innovation Cournot equilibrium, though th
market shares will shrink to (s - d)/(ns + d).7 As a result, in
post-innovation Cournot equilibrium we have mr*r = (s + n
(n + 1)2 and SOL = (s - d)2/(n + 1)2. Firms maximize expecte
discounted profits; firm i's payoff in the R&D game then becom

2R 1Tr*W/r + 2g a XT1*/r +TFi - x,

(7) Vi n
r + 2R a a

We now study the symmetric equilibrium of the R&D gam

Proceeding as in Section II, we obtain the following equilibrium
condition:

(8) 0(2n - l)x - [202(n -1)(,m*- r*)l- - (T* - Ti) = ?-

Equation (8) determines x as a function of n, s, d, and 0, where
0 = g/r. Let x * be the strictly positive solution of (8). We can then
easily derive the effects on the equilibrium R&D effort x * of a
change in the parameters. For the sake of completeness, we state
without proof the following simple results.

PROPOSITION 2. An increase in the efficiency of R&D technology pu

or a decrease in the discount rate r will increase the equilib-
rium R&D effort.

PROPOSITION 3. An increase in the cost improvement d will in-

crease the equilibrium R&D effort.

7. Correspondingly, the winner's market share in the post-innovation equilib-

rium will be (s + nd)/(ns + d). Clearly, the innovation entails an increase in the
degree of industry concentration, which is positively related to the cost improve-
ment d.
8. In a separate technical appendix, which is available upon request, we
demonstrate that the stability condition mentioned in footnote 6 is always satisfied
in this specialized model.

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958 QUARTERLY JOURNAL OF ECONOMICS

PROPOSITION 4. An increase in the size of the market s will increase

the equilibrium R&D effort.9

We now turn to the central issue of this section, namely the

relationship between the intensity of rivalry and the individual
R&D performance. As we have seen, in Lee and Wilde [1980] an
increase in n results in an increase in x *. Proposition 5 shows that
in our model this conclusion may be reversed.

PROPOSITION 5. If n > s/(s - d), then for 0 low enough an increase

in the number of firms n will reduce the individual equilibrium
R&D effort.

Proof. Differentiating (8), we get

(9)
Ax -20x + 202 /a d[(n - 1) (Tr' - mr*)]/n + 0 a('rr* - rr,)/an
0(2n - 1) - [202(n - 1) (IrT7r-*) - 1]/2VF

At the equilibrium point, the sign of the denominator of (9) is

always positive. From (8) it is apparent that as 0 goes to 0, x(0) goes
to 0 with the same speed as 02. (More precisely, we note that the
ratio x/10 tends to (rr - mr) as 0 goes to 0.) It follows that as 0 goes
to 0, the sign of the derivative (9) is determined by the sign of the
third term of the numerator. Since

a 2d[s - n(s - d)]

dn(TrW-rrl)= (n+ 1)3
it follows that as 0 goes to 0 (9) will be negative for n > s/(s - d).

Q.E.D.

Moreover, if the size of the market is sufficiently large, the

aggregate R&D expenditure nx may decrease when n increases, as
the following Proposition shows.

PROPOSITION 6. If s > nd(n + 5)/2(n - 3), then for 0 low enough

an increase in the number of firms n will reduce the aggregate
equilibrium R&D effort.10

9. These Propositions are proved in Delbono and Denicol6 [1988].

10. The expected date of innovation, l/nh(x*), however, is a decreasing
function of n for small values of 0. The reason why the aggregate R&D expenditu
may decrease while the expected date of innovation is always brought forward by
increase in n is that decreasing returns prevail in the R&D technology. A change in
alters not only the degree of competitiveness of the product market, but also the
aggregate technological efficiency of laboratories.

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 INCENTIVES TO INNOVATE IN A COURNOT OLIGOPOLY 959

Proof. Clearly,

anx n Ax

an
an= X
x 1+ --
an+

As 0 goes to 0, all the terms of order 02 or higher in the right-hand

side of (9) become irrelevant, and we get

n Ax nd(n + 5) - 2s(n - 3)
xdAn V0 (n + 1) (nd + 2s)
Q.E.D.

IV. WELFARE ANALYSIS

In this section we compare the market equilibrium with the

social optimum. Specifically, for any given number of firms n, we
study whether the equilibrium aggregate R&D effort, nx*, is
greater or lower than the socially optimal level.
The first best social optimum is obtained when there is perfect
competition in the product market, and instantaneous dissemina-
tion of technological knowledge.1" We continue to assume that
there are n distinct firms: this assumption is irrelevant as the
product market is concerned, given perfect competition and con-
stant marginal costs; however, it matters as far as the R&D
technology is concerned, for the hazard function displays decrea
ing returns. If perfect competition prevails, firms' profits always
equal zero, and social welfare coincides with consumer surplus.
The only effect that Lee and Wilde discuss in their welfare
analysis is the "duplication of efforts," due to the fact that firms do
not take account of the parallel nature of their activities. In the
terminology of this paper, a social welfare maximizer does not
perceive any "competitive threat," as from the point of view of
social welfare it is immaterial which firm innovates first. This
reduces the incentive to innovate of a social welfare maximizer as
compared with that of a private firm, so that there is a tendency by

11. In a longer version of this paper we have also considered second and third
best social optima. They are both characterized by Cournot competition in the
product market; but in the second best world there is instantaneous dissemination
of technological knowledge; whereas in the third best world there is perfect patent
protection. Proposition 7 can be extended to the second best and, under an
additional condition, to the third best world. See Delbono and Denicol6 [1988].

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960 QUARTERLY JOURNAL OF ECONOMICS

private firms to overinvest in R&D. However, an additional effect

turns out to be important in our richer setting, which is the
difference between the "profit incentive" of a private firm and that
perceived by a social welfare maximizer. If the social benefit from
the innovation, as measured by the difference between post- and
pre-innovation social welfare, is greater than the private benefit,
the market equilibrium may exhibit a tendency to underinvest in
R&D.
In a framework as general as the one presented in Section II,
the net balance of these effects is ambiguous. Again, to obtain more
definite results, we tackle the issue in the simplified model of
Section III.
The objective function of the social planner is given by U, the
expected value of the discounted flow of consumers and producer
surpluses, W, over an infinite time horizon:

(10) U H(x)W*/r + W8 - nx
where H(x) = nh(x) is the aggregate hazard function, and it is
assumed that the social discount rate equals the market interest
rate. Notice that, given that there are decreasing returns in the
R&D technology, it is efficient to spread total effort uniformly
across firms. The socially optimal level of R&D effort, denoted by
x *, is then the strictly positive solution of the following first-order
condition:

(11) ~~Onx + VFX- O(W* - Ws) = O.

Before the innovation, consumer surplus (which equals social
welfare) is given by Ws = s2/2, while after the innovation it is W* =
(s + d)2/2.
Lee and Wilde [1980] prove that the socially optimal level of
investment in R&D is lower than the equilibrium investment of the
R&D game, i.e., that firms overinvest in R&D compared with the
social optimum. We show that this conclusion can be reversed in
our model.

PROPOSITION 7. For sufficiently low values of 0, the equilibrium

R&D effort is lower than the first best social optimum, i.e.,
x* < x*S.

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 INCENTIVES TO INNOVATE IN A COURNOT OLIGOPOLY 961

Proof. From (11) it follows that

(12) Fx~ 1 + /1 + 202nd(d

20n
+ 2s)

On the other hand, from (8), neglecting the terms of order 02,
we get

(13) =

-1 + + 402[n(s + nd)2 - ns2 + d(n - 1)(d - 2s)]/(n + 1)2

20(2n - 1)

Since the denominator of (13) is greater than the denomin

of (12), in order to show that, for 0 low enough, x s* is greate
x *, it suffices to show that the term under the square root in
greater than the corresponding term in (13). Remembering t
s > d, a little algebra shows that this is indeed the case.

Q.E.D.

UNIVERSITY OF VERONA, ITALY

UNIVERSITY OF PARMA, ITALY

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