Do firms value knowledge spillover ? A model of R & D competition , spillover and product differentiation ∗ Soma Dey Qiang Fu

How do competing firms choose their research strategies in the presence of knowledge spillover? We propose a model of spillover with consumers uniformly distributed in a linear city. By choosing their product locations, firms determine the amount of knowledge spillover each is going to receive. In a three stage game similar to Kamien and Zang (2000) andWeithaus (2005) we show that whether firms will choose maximum product differentiation or choose the same R&D approach will depend on the extent of consumer heterogeneity and R&D cost parameters. For sufficiently heterogeneous consumers and moderately high R&D costs, symmetric equilibrium with moderate differentiation exists. This is a departure from the existing literature which has found either perfect competition or perfect cooperation as the equilibrium. A simulation exercise shows that higher consumer heterogeneity increases product separation, increases R&D expenditure and increases price. Higher R&D costs, on the other hand, increases both product separation and price, but decreases R&D expenditure. We also find that the equilibrium separating distance between firms is always higher than the optimal separating distance, signifying that firms always choose to differentiate their products more than what is socially warranted. ∗We are grateful to Jay Choi and Hao Wang for helpful comments and suggestions. All the remaining errors and omissions are ours.