On subsidization of investments in R&D and production capacity

Abstract

This article considers a sequential investment project which starts with a product innovation phase, and subsequently, once R&D is completed, a production phase. The investment decisions are the timing and size of the R&D investment, and the size of the production capacity. We show that from a social welfare perspective the firm starts the R&D project too late and installs a too low production capacity. We find that subsidization of the R&D investment is more effective in reducing this welfare loss than subsidization of the production capacity. In fact, we reach the same conclusion under both isoelastic and linear demand.