Abstract: In order to introduce new products to the market, firms can adopt either the incremental innovation strategy, where new products are introduced sequentially from low innovation level to high innovation level, or the radical innovation strategy, where high innovation products are introduced directly to the market with low innovation products being jumped. In this paper, the firm’s optimal product innovation and pricing strategy in the presence of strategic consumers are studied. Using game theory, the pricing and purchasing game between a monopoly firm and strategic consumers under both incremental innovation and radical innovation strategy is considered. Based on the rational expectation of strategic consumers, a two-period dynamic model is developed and the subgame perfect Nash equilibrium is solved. How the extent of the firm’s and the consumers’ strategic behavior would impact the optimal product innovation strategy is then studied. The main results are as follows. First, the optimal product innovation strategy critically depends on the degree of the innovation increment of the high innovation product, the cost difference between high and low innovation products, and the extent of the firm’s and the consumers’ strategic behavior. Second, with the consideration of strategic consumer behavior, the equilibrium radical innovation strategy can not only provide higher profits, but also generate larger market shares for the firm especially when the degree of the innovation increment of the high innovation product is large enough, and/or the cost difference between high and low innovation products is small enough. Third, the more strategic the consumers and/or the firm are, the more the firm can benefit from adopting radical innovation strategy relative to incremental innovation strategy.

Key words: strategic consumer; incremental innovation; radical innovation; dynamic pricing