Vertical Integration and Innovation

Abstract

We studied the impact of vertical integration on investment incentives and social welfare when both upstream and downstream firms make innovative investments. First, we show that vertical integration has larger impact on upstream investments than on downstream investments. When upstream inputs are perfect substitutes, vertical integration leads to upstream crowd-out effect and has no effect on downstream investments. Second, it is only beneficial for firms to integrate when both upstream and downstream innovations are important. And firms may engage in too much integration when only upstream innovation is needed. Third, vertical integration increases social welfare when both upstream and downstream innovation matter; when only upstream innovation is important, vertical integration increases social welfare only if there is strong product differentiation.