ABSTRACT: This research examines the role of diversification on incumbent firms' response to the threat of new entry. When faced with threats posed by new technologies, incumbent firms in the information technology (IT) industry can either perform research and development (R&D), or acquire the new entrants who are successful at innovating. We use a two-stage game-theoretic framework to model the relation between diversification and the decision to acquire versus perform R&D. We also collect data on financial indicators for firms in the IT industry using the Compustat database to empirically test the propositions from the analytical model. Our results suggest that firms with a higher degree of diversification are more likely to innovate through acquisition than through R&D. Moreover, diversification has a positive effect on investment in acquisitions, as well as a negative effect on investment in R&D.
Key words and phrases: diversification, firm acquisition, game theory, innovation, R&D