David P. Baron
Two firms compete in a market vertically differentiated by the qualities of their products. Each firm produces a single product with profit proportional to product differentiation, and initial product qualities maximize product differentiation. In each period a firm can undertake innovation to increase the quality of its product. Product innovation that widens the quality gap between the firms’ products can attract entrants, which can weaken the incentives for innovation. An entrant chooses a product quality in the middle of the quality gap, and its quality is decreasing in the marginal product design cost. Instead of a top dog strategy that makes it a tougher postentry competitor, an incumbent firm uses a smart dog strategy of offering an additional product to forestall entry by narrowing the quality gap. Forestalling entry reduces profit relative to no threat of entry, but the incentive to innovate is preserved by applying an innovation success to the innovator’s entire product line. Growth thus is due to new product introduction and innovation by incumbents rather than to creative destruction by entrants. The threat of entry, however, is the cause of the new products, lower prices, and growth.