We study in a dynamic framework how product innovation activities of a

firm are influenced by its production capacity investments for an established

product and vice versa. The firm initially has capacity to sell an established

product, and it also has the option to undertake an R&D project, which

upon completion allows the firm to introduce a new vertically and horizontally

differentiated product to the market, thereby extending its product range. The

breakthrough probability of detecting the new product depends on both the

value of the firm’s R&D stock and its current R&D investment. It is shown

that the initial production capacity for the established product influences the

intensity of R&D activities of the firm. In particular, there are constellations

such that for large initial production capacity for the established product the

firm never invests in R&D and the new product is never introduced. For small

initial capacity the firm keeps investing in R&D implying that eventually the

new product is always introduced. Finally, for an intermediate range of initial

capacity levels the firm initially invests in product R&D, but then reduces

these investments to zero. In this scenario the new product is introduced with

a positive probability, which is however substantially smaller than 1. From a

technical perspective this analysis gives the example of a new type of Skiba

threshold phenomenon in the framework of a multi-mode optimization model.