R&D cooperation and product market competition

I derive equilibria (that is, self-enforcing agreements) for firms that cooperate in improving their product and compete in marketing it. I am particularly interested in the interaction between R&D and product market decisions along optimal equilibria (that is, equilibria that maximize firm value). I assume that (i) the product is homogeneous and any product improvement is a public good (in other words, spillovers are complete:); (ii) product improvement is a function of the effort by each firm; (iii) firms cannot observe each other's effort; (iv) firms market the product by simultaneously setting prices. The analysis reveals some surprising results. I find that, in some cases, although monopoly prices can be sustained in equilibrium, optimal equilibria call for firms to set lower-than-monopoly prices in the short run, thus providing the right incentives for investment in R&D. Under a different set of assumptions, I find that it is optimal to reduce R&D effort below the efficient level as a means to sustain short-run collusion in prices, even though efficient R&D effort could be achieved in equilibrium. (C) 2000 Elsevier Science B.V. All rights reserved.