Capacity optimization of an innovating firm

Abstract

This article considers an incumbent's product innovation decision within an uncertain framework, where the firm decides whether to continue selling the established product. The model being dynamic allows to analyze the trade-off between an early innovation where the new product only slightly improves the existing one, or innovating late with a much better new product. We find that the effect of uncertainty is that it raises the value of the strategy where the firm keeps on producing the old product after innovating. This results in earlier investment if the firm stays active on the established product market after adopting the new product, and that it keeps on producing the established product for a longer time after the product innovation. Limited uncertainty could lead to a non-monotonicity: with a better new product it is not optimal to innovate, whereas innovating is optimal with a worse one.