Cost Signals under Uncertain R&D Outcomes

Abstract

When it is difficult for firms to differentiate their products from those of their competitors, research and development (R&D) spending on process innovation to lower the cost of production is crucial for profitability. However, the information asymmetry in production costs that results from innovation reduces the efficiency of all firms in a market for a homogeneous good. We employ a signalling game to discuss the feasibility of utilising R&D spending and output levels as cost signals in an environment of quantity competition. The results show that a firm does not spend its money on R&D solely to signal the type of cost. Rather, R&D spending may be chosen as a cost signal over the output level only if expenditures on R&D can lead to a sufficiently high probability of reducing production costs.JEL Codes: C72, D21, D82 I . I n t r o d u c t i o nProcess innovation is important when a product's technology is fully developed and understood. Effective process innovation reduces production costs and offers superior positioning against competitors. Put simply, lowering the production cost for a homogeneous good reflects a firm's competence. Because lower production costs determine firm profitability, it is critical for a firm to acquire information about its opponent's cost of production during the competition process. This information helps a firm to determine its optimal output level in the market. Unfortunately, information about the cost of production is typically asymmetric. 1 Because revealing the production costs is beneficial for the low-cost firm in a quantity competition, it will attempt to send its opponent a signal to indicate its cost 'type'. Conversely, a high-cost firm has a natural incentive to hide its type of production costs to boost its profits. Such behaviour makes it difficult for competing firms to accurately determine their respective profit-maximising output levels. Thus, a cost signal could potentially enhance the efficiency of the market. Intuitively, the first indicator that comes to mind is the spending of a firm on research and development (R&D) because R&D expenditures constitute the most direct spending -related to cost reductions. Information on the R&D spending of firms is not