Innovation and Competition with Asymmetric Information

We investigate the relationship between R&D incentives and product market competition in a model where neither competitors nor contractual parties (e.g., suppliers) are able to observe the exact value of a firm's innovation. The intensity of R&D activity thus affects the rival's perception of the firm's strength, as well as its contractual relationship with third parties. We show that the latter "contractual" effect neutralizes any strategic value of R&D, implying that more intense competition invariably stifles innovation incentives in asymmetric information environments. We also compare the firm and the supplier's attitude towards innovation and find that dissonant preferences over R&D intensity arise when R&D generates positive spillovers on rivals and product market competition is intense. Our results raise the issue of how governance factors (monitoring, control of R&D) interact with product market competition in shaping innovation incentives.