R&D investments with spillovers and endogenous horizontal differentiation

We investigate the implications of cost-reducing R&D activities with spillovers in a Hotelling model with endogenous product differentiation driven by quadratic transportation costs. We consider two different three-stage games: in the first, firms choose locations, then R&D efforts and finally prices; in the second, R&D strategies are decided at the first stage and locations are chosen at the second, with price competition taking place at the third. We identify the conditions whereby process innovation brings about a reduction of product differentiation in equilibrium, consequently implying lower profits. Equilibrium product differentiation and profits are increasing in R&D spillovers. Then, transforming the structure into a twofold version of a four-stage game, we allow firms to commit not to invest in R&D, to show the presence of an underlying prisoners’ dilemma affecting R&D decisions. Finally, we illustrate R&D cartels’ ability to eliminate wasteful sunk costs, and outline policy prescriptions.