Innovation and the principles of product differentiation

Over the last two decades considerable attention has been devoted to two areas of microeconomic theory: the Theory of Innovation and the Theory of Product Differentiation. These have developed largely independent of one another. The Theory of Innovation has focused mainly on process innovation. Whenever it has considered product innovation, it has taken the amount of product improvement, and hence the degree of product differentiation, to be linked very mechanically to the process of innovation. By contrast, the Theory of Product Differentiation has assumed that firms can costlessly introduce whatever new products they wish, and has examined whether the resulting equilibrium satisfies the principle of maximal differentiation or the principle of minimal differentiation. The aim of this Thesis is to investigate the principles of product differentiation in the context of models which takes seriously the idea that new products arise as part of an explicit process of costly innovation. The novel feature of the Thesis is that within this process firms can exercise some degree of choice over the level of differentiation. In such a framework there are two channels through which innovation impacts on the differentiation decision. The first is that, given the stochastic nature of innovation, outcomes of the innovation process are often asymmetric. This contrasts with the assumption of symmetry typically made in the product differentiation literature. It is shown that recognition of these asymmetries can lead to firms pursuing a strategy of minimal differentiation in contexts where, had they been asymmetric, they would have pursued a maximal differentiation strategy. The second channel comes through spillovers. It is shown that these may lead to greater differentiation than would arise with no spillovers. The Thesis considers both cooperative and non-cooperative equilibria, and shows that cooperative equilibria always results in greater differentiation