On the instability of the R&D portfolio in a dynamic monopoly. Or, one cannot get two eggs in one basket

Abstract

Firms' innovation portfolios include several dimensions ranging from organizational aspects to cost reduction and product characteristics. All of these efforts take place during the product life cycle, and interact with each other in determining the spectrum of features of the product and its performance on the market. This paper contributes to the related theoretical debate, focussing on the possibility of having superior product quality levels at lower marginal production cost over time. To deal with this issue, we investigate the optimal R&D portfolio of a single-product monopolist investing in cost-reducing activities accompanied by efforts improving the quality of its product over an infinite time horizon. It turns out that the firm's relative incentives along the two directions are conditional upon market affluence, measured by consumers' willingness to pay for quality, and R&D efforts are complements in the neighbourhood of the steady state equilibrium. However, the dynamics of the two R&D controls depend on both quality and marginal cost at every instant. Consequently, as the stability analysis reveals, the steady state equilibrium is indeed unstable due to the dynamics of marginal cost, thereby implying that one should not expect the firm to supply an increasing quality level at a decreasing production cost. Hence, the dynamic interplay between R&D controls and the resulting instability affecting production costs also imply that one may not expect to observe product quality to increase and market price to decrease over the product life cycle.