Endogenous product differentiation and international R&D policy

•I model the optimal R&D policy for policy-makers when firms compete internationally.•Firms' investments in product innovation depend on the market expansion effect.•When there is a weak market expansion effect the optimal R&D policy is a tax.•However with a strong market expansion effect the optimal R&D policy is a subsidy.

The aim of this paper is to analyse the optimal R&D policy for internationally active firms investing in product innovation. The evidence shows that firms invest significantly in product innovation, and policy makers have shown renewed interest in evaluating potential impact of advances when targeting R&D support. I show that the optimal R&D policy - a tax or a subsidy - depends on the strength of the market-expansion effect, which is linked to the strength of the consumer's preference for differentiated goods. This paper therefore provides a clear rationale for targeting sectors with a strong market-expansion effect with subsidies.