Competitive investments in cost reducing process improvement: The role of managerial incentives and spillover learning

We study the rivalry between two firms and consider the effect of spillovers when the firms' operations and technology managers are given bonuses for cost reduction. We model a game in which the firm owners independently offer their manager a bonus to stimulate cost reducing process improvement before the process improvement and production stage, and draw a comparison with the game in which these bonuses are not used. Several outcomes contrast strongly with existing literature. We find that cost reduction bonuses are generally only positive in equilibrium when spillovers are less than 50%. In case spillovers are higher, cost reduction bonuses are only positive when a firm's process improvement capability is relatively high. Also we find that the sensitivity of process improvement levels in the spillover parameter crucially alters when cost reduction bonuses are introduced. Prisoner’s dilemma occurs in case spillovers are less than 50%, or when spillovers are higher and process improvement capability is relatively high.