Samiran Banerjee and Ping Lin

"Downsteam R&D, Raising Rivals' Costs, and Input Price Contracts," International Journal of Industrial Organization Volume 21, Issue 1, January 2003, pp. 79-96.

JEL codes: L13, L22, O31
Keywords: vertical R&D, raising rivals' cost, fixed-price contract

Abstract: We analyze the incentives for cost-reducing R&D by downstream firms in a two-tier market structure. By increasing the demand for an input, downstream R&D allows the upstream firm to raise its input price. This lowers the benefit of R&D to a downstream firm but raises its rivals' costs. As a result, a downstream oligopolist may invest more in R&D than a downstream monopolist, a phenomenon that is absent in a purely horizontal R&D setting. Fixed-price agreements (where the input price remains unchanged following downstream R&D) promote innovation by eliminating the opportunistic behavior of the input supplier and are welfare enhancing.