Three essays on R & D choice with compatibility externality

by Lee, Jaehee.

This dissertation consists of the three essays on R & D project choice in the presence of compatibility externality. In the first essay we consider a R & D contest between two firms who can choose to concentrate their research in one of two avenues or approaches. In the R & D contest, firms compete in two stages. In the first stage, firms choose which approach they will investigate, after which they endogenously select optimal effort level given firms’ choice of approach in the second stage. There are compatibility externalities if they choose the same approach. However, there is also greater probability of simultaneous discovery which may cause harmful results to both firms. We examine 2 situations with different payoff structures by considering the Bertrand R & D game and the equal sharing R & D game. The equilibrium avenue choice in each game depends on the size of compatibility externality and it may exhibit too much differentiation or too much duplication. The equilibrium effort choice conditional on duplication is inefficiently high in the equal sharing R & D game, while the equilibrium effort choice is efficient when firms choose different research avenues. The result of the excess differentiation and the efficient investment choice in the Bertrand R & D game suggest that the lump-sum investment subsidy may need to be implemented in the US wireless mobile phone industry to reduce inefficiency involved in excess differentiation without distorting efficient investment choice. In the second essay we consider firms’ R & D choice problem where firms may choose the same research approach only through forming a research alliance. When firms agree on forming a research alliance, they play an equal sharing R & D game for the stand-alone value of R & D success, while they split the network value of R & D success according to a certain proportion specified under the research alliance contract. Since firms share the network value of R & D success, firms have an incentive to free-ride on the other firm’s investment. But, due to the payoff structure in which firms receive rewards for its second discovery, firms also have excessive incentive for investment. The interplay of such conflicting incentives result in non-monotonic inefficiency in equilibrium iii investment choice. Especially it turns out that the excessive incentive for investment outweighs the insufficient incentive for investment when compatibility externality is low enough, which results in excess duplication in site choice. In the third essay we consider firms’ dynamic R & D project choice problem in the presence of compatibility externality. Firms which engage in R & D based on risky fundamental technologies (sites) face two kinds of uncertainties: the uncertainty involved in the fundamental technology (whether a treasure is buried in the site) and the uncertainty involved in its own R & D activity (whether R & D succeeds given that a treasure is buried in the site investigated). Each firm carries out two activities in the site that it chooses: production and research. There exists compatibility benefit in both per-period production revenue and the per-period R & D reward when firms choose the same site. Such compatibility benefit which the firms can’t internalize and the nature of competition in the prospective product market interplay to result in over-duplication or overdifferentiation in site choice in the equilibrium. The result of our numerical analysis of the two period game shows that the information benefit through experimentation causes the social optimum and the equilibrium in the two period game to be non-myopic where they involve in differentiation in site choice more often than in the one period game. iv