Dynamic strategic interaction between an innovating and a non‐innovating incumbent

This paper analyzes the effects of product innovation on the firms’ investment behavior in a dynamic duopoly framework. A differential game setting is considered where initially two firms are active on a homogeneous product market. One of the firms has an option to introduce a new product that is horizontally and vertically differentiated from the established product. The resulting differential game has three states corresponding to three capital stocks: one for each firm to produce the established product, and one for the innovating firm to produce the new product. We numerically derive Markov perfect equilibria. One of the most remarkable results is that in most cases the non‐innovating firm benefits when the other firm carries out the innovation option. The intuition is that, to increase demand for the innovative product, the innovative firm reduces capacity on the established market, which increases the price of the established product and thus the payoff of the non‐innovating firm.