This paper applies Nash’s bargaining model to analyze the strategic behavior of two asymmetric firms involved in cost reducing process innovation. In the first stage of the game the R&D expenditures of the firms determine the set of feasible payoff combinations and the disagreement point of a Nash bargaining problem. In the second stage of the game firms cooperate on the output market. This cooperation is taken to coincide with the Nash solution of the bargaining problem. We derive four main results. First, we show that a firm may find it profitable to invest in R&D, even though it will never actually produce at the resulting reduced cost. The explanation is that the R&D outlays give the firm a better bargaining (or threat) position. Second, we show that it is possible that the ranking of the firms in terms of their pre-R&D unit costs may be different from their ranking in terms of their (equilibrium) post-R&D unit costs. Third, assuming that there is cooperation in the output stage, we show that competition in the R&D stage leads to more R&D efforts than cooperation. Finally, if there is competition in the R&D stage, cooperation in the output stage leads to more R&D efforts than competition, provided cost differences between the firms are large.
Group for Research in Decision Analysis