Knowledge Transfer, Transitional Dynamics and Optimal Research & Development Policy in a Dynamic Monopoly Setting

This paper focuses on the question of whether or not a reduction of the knowledge barrier is good for welfare. Based on a dynamic monopoly setting with simultaneous investment decisions in process as well as in product Research & Development (R&D), we show that a reduction of the knowledge barrier has ambiguous welfare consequences: due to a lower knowledge barrier, product quality and welfare increase in the short-run. However, this may not necessarily be the case in the long-run. One reason is that a positive long-lasting knowledge barrier shock triggers the monopolist sub-optimally to reduce its product R&D investments today and in the future at the cost of future product quality. This in turn may reduce welfare. Accordingly, to realize the first-best level of product quality, the long-run optimal R&D subsidy rate for product innovations increases with a reduction of the knowledge barrier.