Strategic Incentives for Innovations and Market Competition

Abstract

We consider a principal-agent model to provide a general analysis of how risk affects incentives of firms who invest in cost-reducing R&D and compete in the product market. We specify the conditions under which higher risk reduces incentives of all firms. We also examine the conditions under which an increase in risk may trigger opposite responses of rivals in the same industry: some firms will strengthen while other firms will weaken the incentives provided to their agents. This result holds regardless of the mode of competition in the product market, Cournot or Bertrand, as long as the rivals' R&D decisions are strategic substitutes. It can generate new empirical implications and can provide an explanation for the lack of strong empirical support in the literature for a negative relationship between risk and incentives. We also discuss policy implications regarding the effect of risk on the incentives to innovate and welfare.