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Keywords:

  • innovation;
  • game theory;
  • decision theory

Do dominant or less dominant firms innovate more? There is considerable research on this question, with theoretical studies based on game theory and empirical evidence often divided. We provide a new theory that the decisions that concern strategic choice in innovation may be influenced by expected relative returns. Our approach, which we call the returns-based beliefs approach, is based upon subjective probabilities. It combines a decision analytic solution concept and Luce's (Individual Choice Behavior, Wiley: New York, 1959) probabilistic choice model. We show that the returns-based beliefs approach provides support for the thesis that dominant firms invest more in research and development (R&D) within an asymmetric mixed-strategy game. Consequently, the returns-based beliefs approach accords better with recent empirical studies of innovation. Using R&D data across a range of industries in the UK from 2001 to 2006, we show that firms’ spending on R&D is related more to their own profitability than to that of their competitors, which is consistent with the returns-based beliefs approach. Copyright © 2011 John Wiley & Sons, Ltd.