Who is the winner in an industry of innovation

Abstract This paper offers insight as to why the average profitability of firms in categories characterized by innovation is high and a rationale for empirical evidence that firms with basic products in innovative categories often exhibit higher profitability than the leading innovator. The analysis is built on the simple fact that not all consumers in a market are willing to pay more for an innovation when it is introduced. Our model reflects price competition between an innovating firm that chooses an optimal level of innovation and a competitor that offers a basic product. The price equilibrium establishes that the innovator confers a significant positive externality on its competitor by innovating. This increases the profitability of both firms. Findings from our model demonstrate that the profitability of the innovator is affected by the cost of innovation, the fraction of consumers who are willing to pay more for the innovation and changes in the cost of producing the improved product. The model identifies market conditions that lead the non-innovating competitor to benefit as much or more than the innovator who invests to develop the innovation. We believe that these dynamics are pivotal in explaining high overall profitability in categories characterized by innovation. The analysis also provides important prescriptions for the management of firms in innovative categories.