COMPETITION, PARALLEL IMPORTS AND COST‐REDUCING INNOVATION

Incorporating parallel imports (PI), we develop a two‐country two‐firm model which relates to the incentives for cost‐reducing innovation. We show that PI may facilitate or inhibit the manufacturers' incentives to innovate. In particular, PI could encourage both firms' innovations. The difference between the manufacturer's profits under successful innovation and failed innovation is either a U‐shaped curve or an inverted U‐shaped curve in terms of the cost of engaging in PI. As these differences reflect the manufacturers' incentive to innovate, the variations in R&D investment depend on transportation cost, and firms' marginal costs before and after successful innovations.