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Innovation plays an essential role in economic growth. Every year, governments, private enterprises, and venture capitalists (VCs) invest billions of dollars and other resources in research and development (R&D) to foster innovation. Often, they are targeting the same group of consumers. This raises a crucial question for innovation investors. How should they allocate their resources to best support innovation in the presence of potential product market competition? After all, investing in direct competitors can have dismal consequences for investors if the market becomes over-saturated. In a timely new study, HKUST’s Pin Gao and co-researchers set out to answer this question.

If an investor puts money into only a few start-ups, it may miss a “unicorn” company. However, investing in many similar R&D projects not only requires more resources but can also intensify competition in the product market. “Private investors and public funding authorities must carefully consider the implications of potential product market competition for resource allocation decisions,” warn the authors. After all, the allocation of financial resources can have a huge impact on various aspects of innovation outcomes.

“These phenomena and questions motivated us to investigate the optimal resource allocation strategy among competing innovators,” the authors explain. Such a strategy would maximize the number of successful innovations and the value of knowledge spillover. To this end, the authors developed and rigorously tested a one-principal, two-agent model with a resource allocation stage followed by an innovation stage.

“We find that when the product market competition is at the moderate level, the resource allocation strategy exhibits an interesting pattern,” the researchers report. The optimal investment diversification first increases and then decreases as the amount of resources increases. “When the amount of resources is small,” explain the authors, “disseminating resources to multiple agents will discourage agents from exerting effort in the innovation process.” When resources become abundant, however, product competition will erode profits when more agents succeed.

“For various industries and different stages of R&D,” say the authors, “diversifying innovation investment can lead to vastly different outcomes.” It is vital to consider the intensity of product market competition when determining resource distribution and investment diversity. Resources may need to be concentrated in some areas and diversified in others. “Increasingly diverse research stimulates productivity, but only up to a point,” the authors warn. “As in any business, a company can spread itself too thin.”

This novel framework and set of results have important policy and managerial implications for both profit-oriented investors and nonprofit funding authorities in today’s age of innovation. “Managers should diversify resources at first to reduce the risk of failure of all projects and concentrate resources in the end to avoid launching too many products onto the market,” the authors conclude.