Winner-take-all, take-most or pay-some? Optimal protection of innovation in a dynamic model of product development

In a model of investment in product development in duopoly we study the implications of different costs of innovating and imitating for firm strategies and optimal IP protection, relating these to the dynamic characteristics of a stochastic demand. A critical relative cost is identified that determines whether strategic competition takes the form of attrition or preemption, with industry value being maximized when firms neither stall nor hasten entry. Provided that demand growth and volatility are sufficiently low, as typically arises in mature industries, it is socially desirable to provide innovators with complete protection (winner-take-all), implying a preemption race. But when demand is rapidly expanding and highly unpredictable a social optimum can involve a low level of protection, implying attrition, albeit with a positive lower bound for the optimal level of imitation cost (winner-pays-some). Industry profits increase if firms can commit not to seek stronger IP protection once they have innovated, providing a rationale for open standards. While buyouts have ambiguous welfare effects, simple licensing schemes are welfare improving