Product Market Competition and Upstream Innovation : Theory and Evidence from the US Electricity Market Deregulation

This paper studies the innovation response of upstream technology suppliers when their downstream technology buyers transition from regulation to product market competition. First, we develop a theoretical framework that models this particular organizational structure. Second, we use the US electricity deregulation in the 1990's to test the model. Using patents as a metric for innovation, we identify two channels through which the effects of deregulation are transmitted to innovation: (a) the appropriation effect which has decreased innovation by 19.5 percent after deregulation, and (b) the competition effect which has increased innovation by 10.7 percent after deregulation. Other unobserved effects of deregulation have led to a 14.5 percent decline in innovation. In aggregate we find that electric technology innovation by electric equipment manufacturers (who were the upstream innovators) has experienced a 23 percent decline due to deregulation. In addition, upstream innovation quality and generality have both declined after the introduction of downstream competition