Market Structure, Innovation, and Vertical Product Differentiation

We reassess Arrow's (1962) [Economic Welfare and the Allocation of Resources for Invention, in NBER, The Rate and Direction of Innovative Activity (Princeton University Press, Princeton NJ)] results concerning the effect of market structure on the returns from process innovation. Here we consider product innovations that are vertically differentiated from older products, in the sense of Shaked and Sutton (1982) (Relaxing Price Competition through Product Differentiation, Review of Economic Studies 49, 3-13.), Shaked and Sutton (1983) (Natural Oligopolies, Econometrica 51, 1469-1484.). Competition and monopoly in the old product market provide identical returns to innovation when (i) the monopolist is protected from new product entry, and (ii) innovation is non-drastic, in the sense that the monopolist supplies positive quantities of both old and new products. If the monopolist can be threatened with entry, monopoly provides strictly greater incentives. Welfare may be greater under monopoly when innovation is valuable.