This paper analyzes how the transferability of production capacities from an established

to a new product influences the incentives of a firm to invest in R&D. A

dynamic duopoly model is considered, where initially both firms offer a homogeneous

product. The firms invest in production capacities and simultaneously in R&D which

determines their innovation rate. The firm that innovates first extends its product line

and obtains a patent for the new product that prevents the other firm from catching

up. Upon the launch of the new product, the innovator then has the option to transfer

part of the capacity for the established product to the production process of the

new product. If capacities can be rolled over to the new product, a trade-off can be

detected in that this rollover option gives the larger firm more incentive to innovate,

whereas the cannibalization effect gives the smaller firm a higher innovation incentive.

As a logical consequence we find that the larger firm is expected to innovate first when

the capacity transfer does not involve a too high capacity loss. However, if the losses

of capacity transfer are considerable, the cannibalization effect starts to dominate and

the smaller firm’s incentive to innovate is larger.