Differentiation as innovation and the impact of competition

Most of the IO literature takes innovation to be either a patentable breakthrough product or some form of cost reduction. In either case, an increase in the number of players (more competition) stifles their incentives to undertake costly innovations because rents decrease. This runs contrary to the common wisdom and seems to defy the most casual observation of the real world. In this paper we let innovation take the form of differentiation. A number N of firms may enter some industry at a sunk cost. They then choose to compete either in an undifferentiated market, where they can invest in cost reductions, or in a differentiated market after paying a fixed cost. The paper’s contributions are the comparative statics results; we find that (i) for a fixed N , investments in cost reductions decrease as the cost of differentiation increases, (ii) N decreases as the cost of differentiation increases, (iii) for a fixed cost of differentiation, the number of differentiated firms increases as N increases. Thus innovation is promoted by competition. JEL Classification: L10, L11, L13, D40, D43.