Vertical integration and incentives to innovate

In this paper, two upstream innovators invest to, improve process innovations used by two downstream producers. At the beginning of the game, each innovator licenses its technology to one producer and they can agree to integrate vertically. Then, investment takes place and successful innovators choose their licensees. When technologies are not costlessly substitutable, the prices of licenses rise with the size of the switching costs. This affects ex-ante incentives to invest, and efficient technologies with low switching costs may disappear. As a result, ex-ante vertical integration is privately beneficial. (C) 2002 Elsevier Science B.V. All rights reserved.