Technology ladders and R&D in dynamic Cournot markets

Motivated by dramatic and unpredictable technological advances in energy production (for instance drilling and extraction of shale oil), we extend Cournot models of competition to incorporate research and development (R&D) that can lead to (stochastic) drops in production costs. Our model combines features of patent racing with dynamic market structure, capturing the interplay between the immediate competition in terms of production rates and the long-term competition in R&D. The resulting Markov Nash equilibrium is found from a sequence of one-step static games arising between R&D successes, and several numerical examples and extensive analysis of the emerging comparative statics are presented. Analyzing the relationship between current market dominance and the level of R&D investments, we find that market leaders tend to invest more, which in some sense makes oligopoly dynamically unstable. We show that anticipated market transitions have long-term impact; for example the potential of future monopoly can spur R&D investment now, even if the firm is presently uncompetitive and not actively producing. We also show that, surprisingly, random innovations have an ambiguous effect on R&D. This feature, which is driven by the Cournot framework, contrasts with the common situation whereby uncertainty lowers innovation and delays R&D investments. Finally, we demonstrate that increased competition may actually increase efforts to innovate through higher desire to achieve dominance. This would match the anecdotal evidence that the threat of market entrants forces incumbents to maintain high R&D.