We study how vertical market structure affects the incentives of suppliers and customers to develop a new input that will enable the innovator to replace the incumbent supplier. In a vertical setting with an incumbent monopoly upstream supplier and two downstream firms, we show that vertical integration reduces the R&D incentives of the integrated parties, but increases that of the nonintegrated downstream rival. Strategic vertical integration may occur whereby the upstream incumbent integrates with a downstream firm to discourage or even preempt downstream disruptive R&D. Depending on the R&D costs, vertical integration may lower the social rate of innovation.
Bibliographical noteWe are grateful to the editor, a coeditor, and two anonymous referees for their suggestions which significantly improved the quality of the paper. We also thank Yongmin Chen, Avinash Dixit, Richard Gilbert, Patrick Rey, Tom Ross, and participants at the International IO Conference at Zhejiang University and the Antimonopoly and Competition Policy Conference at Renmin University for their helpful comments and suggestions. All errors remain our own.
- replacement effect
- structural change
- vertical integration