We model a three-stage duopolistic game, in which firms first simultaneously choose the technological direction of their innovation, then invest in the chosen direction, and finally compete. Investments can be in overlapping or nonoverlapping technological territories, and their outcomes are uncertain. We show that compared to a regime where negligible innovations are patentable, strengthening the requirements for patentability can increase market efficiency. Importantly, we also show that the requirement level may affect the direction of firms' research and development trajectories. While in a mild patent regime firms tend to invest in overlapping technologies, stricter requirements may induce firms to operate in different technological areas, which increases social welfare and consumer surplus. We illustrate our general theory using two stylized Cournot competition models with process and product innovation.
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