OPTIMAL POLICY FOR PRODUCT R&D WITH ENDOGENOUS QUALITY ORDERING: ASYMMETRIC DUOPOLY *

We examine the optimal R&D subsidy/tax policy under a vertically differentiated duopoly. In a significant departure from the existing work, we consider the case of asymmetric costs of product R&D where there is a small technology gap between firms. In our analysis, the endogeneity of quality ordering is explicitly taken into account. We demonstrate the possible anti-leapfrogging effect of R&D subsidy/tax policy. By committing to a firm-specific subsidy schedule contingent on firms' quality choices, the government can not only correct distortions in product quality but also select the socially preferred equilibrium. The latter role is fulfilled by preventing the technologically inferior firm from becoming a quality leader in the industry. Both Bertrand and Cournot cases are analysed. Copyright Blackwell Publishing Ltd/University of Adelaide and Flinders University 2006..