No. 658 - R&D and market structure in a horizontal differentiation framework

This paper examines the dynamic interaction between R&D and market structure in a horizontally differentiated market framework. Firms invest in R&D to modify the level of differentiation of their products, increasing their specialization and their market power. The invested resources in research are declining over time because of decreasing returns from further specialization. Prices, output and short-run profits of the firms producing differentiated products increase and move towards the higher steady state values, while production of the non-differentiated good falls; the number of firms is constant in all periods. The increasing specialization of varieties improves the overall utility of consumers. The comparison with the socially optimal solution shows that firms underinvest in R&D. Firms do not internalize the effects of their research effort on the overall level of substitutability of the other varieties and on the profits of the other firms.