Strategic Incentives for Innovation and Product Market Competition

We consider a principal-agent model to examine the relationship between risk and incentives of firms who invest in cost-reducing R&D and compete in the product market. We show that a change in risk may trigger opposite responses of rivals in the same industry: lower risk may induce some firms to strengthen, while other firms to weaken the incentives provided to their agents. This result holds regardless of the mode of competition in the product market, Cournot or Bertrand, as long as the rivals’ R&D decisions are strategic substitutes. Our model can generate new empirical implications and can provide an explanation for the lack of strong empirical support in the literature for a negative relationship between risk and incentives. It also has policy implications about the effect of risk on the incentives to innovate and welfare.