Cooperative and non-cooperative R&D policy in an economic union

What are the consequences of decentralized R&D policies within an economic union? Do non-cooperative policies generate too high R&D subsidies? To address such questions, we construct a simple model where firms invest in quality-improving R&D. With goods produced in different countries within an economic union, we compare non-cooperative and cooperative R&D policies. We show that non-cooperative policies imply too small R&D subsidies for horizontally differentiated goods and too high subsidies for close substitutes. Furthermore, small countries have less incentive to subsidize R&D than large countries, resulting in an unwarranted vertical product differentiation between goods produced in different countries.