A model of R&D with internal and external sources of knowledge as substitutes

We explore how substitutability between internal and external R&D influences the business conduct of innovative firms with regard to R&D approaches and investments in competitive and cooperative innovation games. To this purpose, we develop a duopoly model which incorporates the assumption of substitutability arising between internal and external R&D due to diseconomies of scope in firms using different innovation mechanisms. Most results of our model are qualitatively different from those of earlier models of R&D with exogenous spillovers or endogenous absorptive capacity determined by R&D approaches. We find that firms are likely to adopt the same research approach regardless of whether they cooperate or compete in R&D. The two versions of our model make the same prediction concerning the specificity of the firm’s R&D agenda. The cooperative equilibrium entails always either a higher or a lower level of individual R&D output relative to the non-cooperative case. Developing innovations exclusively in-house provides the advantage of higher efficiency of R&D investments and induces higher technological progress than opening some of one’s knowledge to other firms and tapping into external sources of knowledge. We find a tension between the knowledge disclosures resulted from the R&D generality of a firm’s research approach and the protections of innovation returns facilitated by the R&D specificity of its research approach that arises as a paradox for firms. The finding of a positive association between the choice of a firm to be connected with the R&D environment and the appropriability of its innovation returns is understood to be consistent with the empirical result of a paradox of openness that firms open to external sources of innovation face. We expect that the probability of cooperation in R&D is increasing in the strength of legal intellectual protection. Firms that are more effective in strategically protecting their valuable knowledge through the choice of research approaches are more inclined to start a research joint venture.