In this paper we carefully link knowledge flows to and from a firm's innovation process with this firm's investment decisions. We present a model of a leading technological firm facing a competitive fringe. The leading firm considers three types of investments: investments in applied research, investments in basic research, and investments in intellectual property protection. By doing basic research, the leading firm can effectively access incoming knowledge flows. These incoming spillovers serve to increase the efficiency of own applied research. The leading firm can at the same time influence outgoing knowledge flows, improving appropriability of its innovations, by investing in protection. Our results indicate that the leading firm with a small budget for innovation will not invest in basic research. This occurs in the short run, when the budget for know-how creation is restricted, or in the long-run, when market opportunities are low, when legal protection is not very important, or, when the pool of accessible and relevant external know-how is limited. Once this firm starts accessing external know-how by spending on basic research, the ratio of basic to applied research is non-decreasing in the size of the pool of accessible external know-how, the size and opportunity of the market, and, the effectiveness of intellectual property rights protection. This indicates the existence of economies of scale in basic research due to external market related factors. © 2002 Elsevier Science B.V. All rights reserved.