Product Innovation in Vertically Related Industries

We compare a downstream firm's incentive to invent a new input under vertical separation and vertical integration. Similar to the replacement effect in horizontal settings, innovation by a vertically integrated firm replaces its current upstream business. Innovation by a vertically separate firm leads to dramatic changes to the vertical market structure: It generates an integration effect as well as a relationship-reversal effect when the innovating firm's downstream rival is integrated. Unlike the case of horizontal mergers, unambiguous results are obtained on the effect of vertical mergers. In particular, we show that vertically integration always reduces the merging firm’s R&D incentive, but enhances the R&D incentive of non-integrating firm.