A Sequential Model of R&D Investment Over an Unbounded Time Horizon

A Markov model of sequential R&D investment, where successful firms are assumed to have an advantage in related follow-on R&D, is formulated and a solution approach is given. Under this assumption, profit maximizing firms must consider the effect of R&D investments on their future market position as well as the direct monetary returns from innovation. Under certain conditions, free entry is shown to lead to excessive competition and overinvestment by the firms. This market failure can be corrected through a three-part policy of restricted patent lives, subsidies to firms for consecutive successes, and entry taxes. In addition to these policy conclusions, the modeling and solution approaches presented here provide a framework for further research efforts to incorporate market position into project selection and budget allocation models.