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Capacity Investment and Product Innovation Leadership

We employ a dynamic duopoly game with evolving demand structure to study the interplay between the firms’ product innovation activities and their investments in capacities for an established product. After deriving a Markovperfect equilibrium we conclude that the firm with a larger market share for the established product is less likely to be the first innovator. Innovation activity is negatively affected by the opponent’s production capacity on the established market if the opponent has not innovated yet, but this effect is reversed after the opponent’s innovation. A comparative cost disadvantage on the established market results in a higher incentive to innovate and potentially in a larger firm value. Furthermore, innovation activities in the Markov Perfect equilibrium are too low from a welfare perspective.