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.
Copyright © 2003 Elsevier Science B.V.
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