Ho(s)telling Porter's Ideas : Horizontal Differentiation and Product Innovation

We use a Hotelling-type model with innovation in order to explore some of the main guidelines proposed by M. Porter (1991) in what refers to competitive advantage by differentiation and innovation. We find that Porter's remark about the fundamental importance of innovation as the origin of competitive advantages is particularly relevant in the case of dealing with a product innovation that generates a high improvement on the consumers' surplus in relation to the level of horizontal differentiation and the cost of investing in R&D. In that case, the firm that initiates the R&D program get higher profits than the competitor. Nevertheless, under different conditions the decision to initiate an R&D program would be followed suit by the rival firm and the profit level becomes the same for both companies. We also observe that when there is only one firm investing in R&D there is a negative relation between the level of horizontal differentiation and the incentives to invest in R&D. This result is suggesting that if consumers can easily move between goods (i.e.: the transport cost in terms of consumer's surplus is low), firms will try to differentiate in quality through an increase in R&D. When both firms initiate R&D programs, the level of R&D investment is independent of the horizontal-differentiation parameter. Finally, calculating the Total Surplus (TS) of each equilibrium we observe that the case when only one firm invests in R&D is preferable to the case when both or no firms decide to invest. The difference in TS is increasing both in the innovation's contribution parameter and in the innovation cost, but it is decreasing in the level of differentiation