Vertical Integration and Disruptive Cross-Market R&D

We study incentives for innovations that enable firms to enter backward into the input market. Such innovations are disruptive in that they lead to structural changes and even reversal of supply-customer relationships. We first show that Arrow's replacement effect is also present in our vertical setting which gives rise to two general results: (1) vertical integration lowers the R&D incentive of the integrated downstream firm; and (2) vertical integration raises the R&D incentive of the non-integrated downstream firm. We then identify, respectively, situations for strategic integration, which is driven by the motive to preempt R&D of the target firm, and for strategic separation, which occurs as a means to not trigger R&D by the downstream rival. An otherwise profitable raising rival's cost strategy may not be chosen for fear of counterattack by the rival in the form of disruptive R&D.