Innovation incentives in an integrated market with vertical product differentiation

This paper aims to examine whether integration of national markets fosters innovation in the technologically inferior country.

The authors examine a simple game theoretic framework where a technologically backward home firm and a technologically advanced foreign firm compete in both qualities and prices in an integrated market. They formalize the speed of response to market integration of the two countries as a first mover advantage in the R&D stage.

The authors find that the outcome depends on the speed of response of the two firms and their initial technological distance. If the domestic firm is not too far behind the foreign firm to begin with, and if it responds faster, then the technological gap may get reversed. Further, the authors find that integration may be welfare improving for both the countries. There are, however, distributional implications. While the consumers always gain from such integration the firms may not.

This paper contributes to the debate on the implication of market integration. In contrast to the literature the authors use a model of vertical product differentiation which is relatively less explored in the literature and formalize the speed of response to market integration as a first mover advantage in R&D. This allows them to establish several interesting results with interesting policy implications.