THE INCENTIVES FOR COST REDUCTION IN A DIFFERENTIATED INDUSTRY

This paper investigates how the incentives for cost reduction in a differentiated industry depend upon the degree of product substitutability. When goods are imperfect substitutes, both Cournot and Bertrand competition result in underinvestment in the sense that a social planner would be willing to pay more for a given cost reduction than a profit-maximizing firm. Overinvestment may occur when the goods are sufficiently close substitutes. Similarly, Cournot competition provides a stronger incentive to innovate than Bertrand competition if the degree of substitutability is low, and a weaker incentive if this degree is high.