Merger and Innovation Incentives in a Differentiated Industry

In this paper, we consider a duopoly with product differentiation and examine the interaction between merger and innovation incentives. The analysis reveals that a merger tends to discourage innovation, unless the investment cost is sufficiently low. This result holds whether or not side payments between firms are allowed. When side payments are permitted, a bilateral merger-to-monopoly is always profitable, a standard result in the literature. When side payments are not permitted, however, we show that a merger is not profitable when the efficiency of the new technology is relatively high and the investment cost is below a particular level.