Does Microsoft Stifle Innovation? Dominant Firms, Imitation and R&D Incentives

We provide a simple framework to analyse the effect of firm dominance on incentives for R&D. An increase in firm dominance, which we measure by a premium in consumer valuation, increases the dominant firm's incentives and decreases the rival firm's incentives for R&D. These changes influence the probability of innovation through two effects: changes in total R&D effort and changes in how this total is distributed between the two firms. For a given level of total research effort, the shift from the rival firm to the dominant firm is a good thing as it decreases the likelihood of duplicate innovation (we call this the duplication effect). The shift in research effort is not one-to-one, however. The dominant firm's benefit from increased dominance is more inframarginal than marginal when compared to the rival firm's disincentive. As a result, total research effort decreases when firm dominance increases (we call this the total effort effect). We show the total effort effect dominates the duplication effect when intellectual property protection is weak, and the opposite when property rights are strong. That is, firm dominance is good for innovation when (but only when) property rights are strong. We also examine consumer and social surplus.