We employ a dynamic market model with endogenous creation of submarkets to study the optimal product innovation strategies of incumbent firms. Firms invest in production capacity and R&D knowledge stock, where the latter determines the hazard rate of innovation. We find that under Markov Perfect Equilibrium behavior the firm with a larger market share on the established market is less likely to be the first innovator. Investment in R&D knowledge is negatively affected by the opponents production capacity on the established market if the opponent has not innovated yet. However, this effect is reversed after the opponent has successfully introduced the new product. The firm with higher costs of adjusting capacity for the established product has a larger incentive to engage in product innovation and might even achieve higher long run profit than its more efficient competitor.