This paper deals with the strategic reaction of firms to competitive threats stemming from newly developed products of current competitors. Due to the fact that product innovation projects go through multiple time consuming stages with multiple continuation/termination decisions, competitors can react to the threat before the new product is introduced and thereby may prevent or facilitate the product introduction. We consider a quantity-setting duopoly model where Firm 1 can start a two-stage product innovation project for obtaining a horizontally and vertically differentiated product. In-between the two stages Firm 2 can react by investing in cost-reducing process innovation. We find that under weak vertical differentiation Firm 2 wants Firm 1 to innovate. Horizontal differentiation softens competition and Firm 2 over-invests in process innovation to induce Firm 1 to launch the new product. Second, under strong vertical differentiation Firm 1 starts the product innovation project –triggering under-investment by Firm 2 – but never finishes it. The under-investment leads to higher production costs for Firm 2, which induces Firm 1 not to innovate. Third, under very strong vertical differentiation Firm 2 prevents a launch of the new product by over-investing in process innovation. Due to the strong decrease in production costs Firm 2 captures such a big market share that Firm 1 will not introduce the new product. In such a scenario the situation of Firm 1 in the old market also has become worse, and therefore the option to complete the innovation, which is created by initiating the first stage of the innovation project, has a negative value for Firm 1.
Group for Research in Decision Analysis