Economics Letters 37 (199 I) 1X7-IYI IX7

North-Holland

Incentives for cooperative and non-

cooperative R and D in duopoly

Received I4 February I’JY I

Accepted I.7 May 1991

This paper tries to explain why duopolistic firms would like to enter cooperative R and D ventul-r even when they would act
non-cooper;ltively in the product market. We show that both ‘very high’ and ‘very low’ probabilities of ~uccrss in R and D
can induct firms to go for R and D joint ventures. This research highlights the modus operandi for cooperative research
even without and ‘spillover’ of individual R and D and/or with a reasonably ‘low sunk cost of R and D.

1. Introduction

Oligopolistic models of industrial organization often assume that inter-firm relationships arc
entirely cooperative or non-cooperative. Therefore, such models can not be applied to situations
where firms like to cooperate at some level of operations whereas they would like to outcompcte
one another in some others. In particular there are a few models to capture the notion of R and D
joint venture along with imperfectly competitive product markets where products are nothing but
outcomes of cooperative R and D activities. Examples of situations where firms cooperate at the R
and D level and act non-cooperatively at the marketing level are given by the European Strategic
Program for R and D in lnformation Technologies (ESPRIT), the microelectronics and Computer
Technology Corporation (MC0 in the United States and very Large-Scale lntegration Program
(VLSI) in Japan. Firms are also observed to collude at bothlevels of operations. The welfare
implications of such two stage collusions are generally ambiguous. Reducing duplication of R and
D expenditure generates a welfare gain which may be outweighed by the collusive effect on the
price. This was ably demonstrated by d’Aspremont and Jacquemin (198X).
In this paper we shall talk about the first kind to strategic arrangements. Katz (19%) has
provided us with a detailed analysis of R and D joint ventures where firms choose varying levels of
R and D spending in cooperative and non-cooperative situations. Katz (1986) primarily discusses
the welfare and policy implications of different types of arrangements. Both Katz (1986) and
d’Aspremont and Jacquemin (1988) ’ do not consider uncertainty in their models. R and D

* The author wishes to thank R. Preston McAfee and Debraj Ray for extremely rewarding discussions during the
presrnfation of this paper in the ‘International Confcrencc on Game Theory and Economic Applications’ held at ISI
Delhi. The usual disclaimer applies.
’ An interesting non-technical paper in this context is by Grossman and Shapiro (1986). Also see Ordover and Willig (lY85).
Gandel and Scotchmer (1984), Suzumura (1989), Kamien, Mullcr and Zang (IYYO) etc. To the best of my knowledge none
of thege papers study specifically the impact of uncertainty on natural incentives for cooperation in R and D.

~~lh~-l7~~S/91/$03.50 0 1991 ~ Elsevier Science Publishers B.V. All rights reserved

spending directly affects the cost levels and therefore R and D joint ventures tend to reduce the
wastage of resources to bring down the cost of production.
In this paper we shall try to provide some rationale behind private incentive for cooperative R
and D when effects of R and D are random. We shall abstract from the ‘spillover’ nature of R and
D projects which might otherwise generate incentives for cooperative R and D. We shall show that
‘drastic’ research projects with a high chance of success or high chance of failure should pull
competing firms together in a cooperative R and D venture although they eventually compete in
the product market.

2. Model

We have symmetric duopoly with each of the firms earning 7~ as non-cooperative Cournot-Nash
profit in the product market. Each firm wants to do R and D in the initial stage. They can do it
either in a cooperative way or can go ahead independently. Whatever they choose to do with their
R and D, collusion in the product market can not be sustained. Process of R and D involves
spending a fixed sum F to set up the research lab. R and D reduces the marginal cost of
production and increases profits. However, each firm faces probability P of success. The innova-
tion, if occurs, is drastic which implies that if either of them manages to be successful, he emerges
to be a monopolist. In case both of them are successful, a new symmetric equilibrium arises with a
lower cost. rr,,, denotes the level of monopoly profit and 7i denotes individual non-cooperative
profit in the post-innovation game, if the R and D effort is successful. The following describes the
two stage game in the extensive form.
The game tree is drawn with the following symbols,
D,-strategy that the ith firm chooses to do R and D, i = 1, 2.
ND; = Strategy that the ith firm choose not to do R and D.
C = firms cooperate, NC = firms do not cooperate

R & D decision of the first firm

DZ(C) D2(NC)

Fig. 1
 S. Marjit / Incentit~es for K and D in duopoly

The pay offs are the following:

(ND,, I&) + [(l -P)7r, P%-,,+ (1 -I+--_I:

P( 1 - P)7-rm + P27i + (1 - p)2Tr - F])

(D,, NDz) + [Prrn+(l -P)%--F, (1 -P)%-1.

At this stage two observations are in order.

First, since the firms are symmetric, same picture would arise if the second firm decides to move
first and the pay offs will remain the same. Second, cooperative form of R and D is assumed to
operate in the following way. Firms jointly make a draw and the information or the outcome is fully
revealed to both of them. They share F equally and therefore each can have a pay off P+ + (1 -
Ph - +F. In the case of non-cooperative R and D, the net pay off is

P(1-P)rr,,+P27i+(1-P)2~-F-(1-P)~. (1)

Similarly for cooperative R and D,

P++(l-P)T-;F-(l-P)T. (2)

Since we are concerned with the relative profitability of (1) and (2), we shall assume both to be
positive. The solution is trivial if either of them is positive. Positivity of (1) justifies why (ND,, ND,)
can not be an equilibrium and the relevant pay off to the first firm is (1 - P)lr if it chooses not to
do any R and D. This can be proved in the following way,

= P+T,,, - (r-t&)] >O as r,,, > 2s and 7i > r ‘.

Therefore, if (1) is positive then PT,,, + (1 - Ph - n- > F which rules out ‘no R and D’ as a
possible equilibrium. Since both (1) and (2) are assumed to be positive, duopolists will like to
cooperate if (l)-(2) < 0

+P(I-P)[T~~-(T++)] <;F. (3)

’ In Bertrand Price game with homogeneous good, there should not he any incentive for cooperative R and D as long as
product game is non-cooperative. One can interpret the profits as outcomes of price games in a differentiated goods
market. The innovation might be finding the appropriate product-brand. All the results in the paper can be readily
interpreted in that case.
Left-hand side of (3) is a non-monotonic function of P. In particular,

W(l -P)l =o_p= i

(9
2’
dP

Also note that

d’[PV +‘)I = _2.

dP2

P(1 - P)[7T*,, - (r + 7i)] has been depicted in fig. 2. Now, one can establish the following proposi-
tion.

Proposition I. Let P, < c2 be the two roots of the equation P(l - P)[T,,~ - (TT + +)I = +F, then
VP E [0, P,) and VP E (P,, l] research joint llenture is more profitable than independent R and D.

Proof. Since P(l -P) reaches a maximum at P = i, as P(l - P)[T,,,, - (T + +I = +F have hm

solutions (P, < P,), it follows that,

Now d[ p( 1 - P)]/d p > 0 for P[O, i). Therefore, for P E [O, PI ), P(1 - P)[T,~ - (7i + < + +)I < $AF.
Similarly, for P E (i, 11, d[P(l - P)]/dP < 0. Therefore, for P E (Pz, 11, PC1- f’)[~,,~ - (r + r)l
< +F. 0

The result can be intuitively justified. One should note that the incentive for ‘go-alone’ heavily
depends on the other player’s failure to achieve success, i.e. on the possibility of a monopoly
situation. Since the firms arc symmetric, product probability P(l - P) will be low for very high or
very low values of P. If the probability of success is very high for a player, the probability of failure
for the other player also is very low and ‘monopoly’ is almost an impossibility. Therefore, no player
should have any incentive to go for independent R and D. Sharing of the R and D expenditure
seems to be quite an incentive for pooling individual R and D efforts. However, even if F is not
very high, there are situations where firms will pool their research efforts in a joint venture where
P(l -P) is low.
 S. Murjit / Incentixs for R and D in duopoly 191

3. Conclusion

In this short paper we have discussed the role of uncertainty in the process of R and D when the
firms compete in the product market. To isolate the effect of randomness, we have used a very
simple model by assuming that the R and D effort and eventual cost reduction is not functionaly
related. What we have tried to show is that cooperative R and D tends to be profitable when both
firms are not likely to succeed ‘alone’ through independent R and D effort. This case arises when
success probability is either too high or too low for a set of symmetric firms.
The basic point of the paper is that firms can have natural incentives to cooperate even when
there is no ‘spillover’ and/or sunk costs of R and D is not that high. This might be determined by
the nature of the technology and relative positions of the competing firms. If the technology
concerned is highly developed and the probability of further breakthrough is low, firms will be
inclined to go for joint ventures. If the success probability is high but the competing firms are
symmetric, even drastic innovations might not be attractive enough to go for independent R and D.

References

d’Aspremont, C. and A. Jacquemjn, 1988, Cooperative and non-cooperative R and D in duopoly with spillovers, American
Economic Review, Dec., 1133-l 137.
Gandel, N. and S. Scotchmer, 1989, Coordinating research through research joint ventures Domestic studies program
(Hoover Institution, Stanford University, Stanford, CA).
Grossman, G. and C. Shapiro. 1986, Research joint ventures: An antitrust analysis, Journal of Law, Economics and
Organization 2, 3155337.
Kamien, A.. E. Muller and I. Zang, 1990. Research joint ventures and R and D cartels, Mimeo. (Kellog Graduate School of
Management, Northwestern University, Evanston, IL).
Katz, M., 1986, An analysis of cooperative research and development, Rand Journal of Economics 17, 527-543.
Ordover, J.A. and R. Willig, 1985, Antitrust for high technology industries: Assessing research joint ventures and mergers,
Journal of Law and Economics 28, 311-333.
Suzumura. K., 1990, Cooperative and non-cooperative R and D in oligopoly with spillovers, Mimeo. (The Institute of
Economic Research, Hitotsubashi University, Tokyo, Japan).