Firms improve their production technology through a variety of means, many of which are unobservable to the outside world. This is, in particular, true for a very significant proportion of innovations and other production efficiency gains that arise through learning, internal research and development (R&D), and accumulation of organizational capital. As many of these gains are not patentable, firms prefer to retain privacy of information about their actual cost and technology structure. More interestingly, it is difficult for existing rivals, potential competitors, and other stakeholders in the industry to readily acquire information about efforts and inputs expended in the R&D process of a firm. In competitive markets, the absence of observability of R&D investment or efforts undertaken by other firms is likely to influence the strategic incentive to invest, the extent of actual technological improvements, and the eventual market outcomes. This leads to an important question about the effect of privacy of such information on technological change and social welfare. If such secrecy is not socially desirable, then there would be a case for public policy to discourage secrecy and promote sharing and disclosure of information about R&D investments made by the firms. This paper attempts to analyze the potential impact of secrecy of the level of R&D investment made by the firms in a market characterized by privacy of information about the actual cost structure of the firms i. e., their actual production technology.
My paper draws on the seminal work of Gal-or (1986) who finds that firms strategically competing in prices do not have any incentive to disclose information about their own cost of production. In this paper, I assume that firms keep their final outcome of process innovation secret and primarily focus on the role of (exogenously given) secrecy of strategic R&D investment. Moreover, in contrast to this paper, the existing literature has largely focused on issues related to the observability of cost or R&D outcomes. Thomas (1997) examines the incentive for cost-reduction by a single firm in an industry where firms differ in their initial cost and shows that this unilateral incentive for cost-reduction is higher when information about actual production cost is privately held.
In particular, the paper analyzes an ex ante symmetric homogenous good duopoly where firms engage in process innovation (that reduces production cost) and price competition. The firms simultaneously decide whether to invest in cost-reduction and after this, they compete in prices. The realized cost-reduction is uncertain and depends on the amount of investment. Each firm observes its own realized production cost outcome prior to price setting but remains unaware of the actual outcome of the R&D investment made by its rival. I compare the incentive to invest in cost-reduction and the market outcome generated in this extensive form with the secrecy of investment to the equilibrium outcome of an alternative extensive form where the level of R&D investment is publicly observed before price setting. The realized cost i. e., the outcome of R&D is assumed to be private information in both extensive forms.
The main result of the paper is the equilibrium outcome under secrecy of R&D investments yields higher social welfare than public observability of (or information sharing about) investment. Further, secrecy may yield higher total amount R&D investment and higher expected profit for firms.
One implication of this is that there may not be any case for public policy to encourage information sharing arrangements among competing forms about R&D investments. Further, there is some benefit from the protection of information about expenditures, inputs or efforts going into firms’ R&D processes through trade secret laws 1 and deterrence of competitive intelligence gathering activities 2 related to R&D investment or inputs.
The paper is organized as follows. Section 2 describes the model. In Section 3, I discuss the pricing and investment outcomes under incomplete information when R&D investment is secret and when it is publicly observable.
2 The Model
I consider an oligopolistic market with two ex ante identical firms that compete in prices and produce a physically homogenous product. The production technology of each firm can be of two potential types: high-cost (H) and low-cost (L): Each firm produces at constant unit cost. The unit production cost of a high-cost type (defined by cH) is greater than that of a low-cost type (defined by cL) i. e.,
Firms are initially endowed with high-cost technology i. e., each firm incurs a unit production cost of cH. Firms can invest in R&D of a new cost-reducing technology. However, the outcome of the investment is uncertain, and the probability of success is positively related to the cost of investment. The cost of investment is given by
In the first stage, the firms simultaneously decide how much to invest (viz.,
3 Observability vs Secrecy
After the strategic investment decisions in the first stage, a firm gets to know the actual outcome of its own investment in the cost-reduction, but does not learn anything about the rival’s R&D outcome. Therefore, when the firms simultaneously choose price of their product they are not aware of each other’s marginal cost of production i. e., a firm does not know whether the rival has successfully adopted the low-cost technology.
To begin with, I solve the second stage (incomplete information) subgame where firms choose prices simultaneously with the private knowledge of their own production technology
5. Without any loss of generality, I assume that
The high-cost type charges a price equal to its own unit production cost
First, note that there does not exist any Bayesian price equilibrium in pure strategies. The reason is as follows. The low-cost type has competitive advantage over the high-cost type since
At any price
A firm earns a strictly positive expected profit because of its strictly positive investment. Moreover, the expected profit of the firm with higher investment depends on the probability of failure of the rival with lower investment, but not the vice versa; because the low-cost type of the firm with higher as well as lower investment earn the same expected profit over the (same) price interval. Note that the Bayesian pricing equilibrium is the same irrespective of the observability of the firms’ strategic investment decisions.
First, I consider the case where the strategic investment decisions become observable. In the first stage, firm i chooses
Under incomplete information withobservableinvestment, firms choose
I evaluate the best response function of each firm (i. e., given
Observe that for any
Figure 1 depicts the reaction functions of the firms (denoted by eq. ). In the asymmetric Bayesian Nash equilibria (represented by E1 and E2), one of the firms chooses investment such that it becomes low-type with probability one
Finally, I study the equilibrium investment behavior when the investment in cost-reducing technology remains private knowledge. In other words, a firm knows its own type but is unaware of both the investment and the actual outcome of the rival. Note that in this multistage imperfect information game, the nature of pricing equilibrium outcomes is similar to that of the incomplete information one discussed in Lemma 1.
Under incomplete information withunobservableinvestment, firms choose
The expected profit from deviation is maximized at
From the above propositions, one can make the following observations:
- (1)When the investment decisions remain secret, both firms engage is symmetric investment behavior in the equilibrium unlike the case where investment is observable i. e.,
- (2)The ex ante expected profit earned by each firm under secrecy is higher than that of under observable investment i. e.,
- (3)The aggregate (or industry level) investment in R&D under secrecy is higher compared to no secrecy (about the investment behavior) when
- (4)The aggregate (or industry level) ex ante expected profit under secrecy is higher
- (5)Social surplus is maximized when a firm charges its own marginal cost. Thus, the expected total surplus is equal to
which is maximized at
I find that the ex ante total expected profit of the industry as well as the social welfare are higher when strategically competing firms keep their R&D investments in cost-reducing technology secret compared to the case when such information is public observable. This implies that the government intervention to secure disclosure of R&D investments may be counterproductive and the trade secret laws that protect privacy of information related to R&D inputs or investment may be conducive to innovation.
In the US, state governments choose to adopt conveniently modified versions of the Uniform Trade Secret Acts (1979).
Alternatively, one can think that the firms choose the probability of successful investment in cost-reducing technology i. e.,
This essentially means that since firm j has a lower probability of being successful in adopting the low-cost technology compared to its rival firm i, firm j charges the upper bound of the price interval (i. e., cH) with zero probability.
It is easy to prove why symmetric equilibrium does not exist. Assume that