© 2008 The Author Journal compilation © 2008 Blackwell Publishing Ltd /University of Adelaide and Flinders University Blackwell Publishing Asia Melbourne, Australia AEPA Australian Economic Papers 0004-900X 1467-8454 © Blackwell Publishing Ltd/University of Adelaide and Flinders University of South Australia 2008 XXX ORIGINAL ARTICLE DOWNSTREAM R&D RIVALRY WITH SPILLOVERS AND DISCRIMINATORY INPUT PRICING XX DOWNSTREAM R&D RIVALRY WITH SPILLOVERS AND DISCRIMINATORY INPUT PRICING PEI-CHENG LIAO* National Taiwan University This paper examines how discriminatory input pricing by the upstream monopolist affects the R&D choices of downstream duopolists in the presence of R&D spillovers. We show that the monopoly supplier can benefit from a precommitment to uniform pricing because under uniform pricing the downstream firms invest more in R&D, leading to larger output and thus benefiting the supplier. When R&D spillovers are sufficiently large, the downstream firms are also better off under uniform pricing. Moreover, social welfare is always higher under uniform pricing. I. I ntroduction This paper combines the literature on R&D choices and input-market price discrimination in an analysis of how the profits of the upstream and downstream firms and social welfare are affected by R&D spillovers, R&D investment, and input pricing schemes. R&D spillovers are frequently invoked in empirical and theoretical research related to R&D, and the existing literature has shown that R&D spillovers are prevalent and pivotal. The paper is related to the literature on R&D competition and/or cooperation in oligopoly with R&D spillovers, mainly focused on how R&D efforts are affected by the level of R&D spillovers. 1 More explicitly, the focus of the paper is on strategic R&D investment games and on process innovation to reduce production costs. In a seminal paper, d’Aspremont and Jacquemin (1988), henceforth AJ, show that cooperative R&D levels exceed non-cooperative R&D levels when the degree of spillovers exceeds 0.5, and vice versa. Many subsequent papers have adopted their framework with modifications to analyse other related issues. For example, Kamien et al. (1992), henceforth KMZ, extend the AJ model to more firms than two, a general concave R&D production function, differentiated products, and Bertrand price completion; 2 Suzumura (1992) extends the AJ model to general demand function. There are also many papers considering different issues, such as product innovation, vertical cooperation, international research joint venture, and absorptive capacity. 3 doi: 10.1111/j.1467-8454.2008.00355.x Correspondence: Department of Accounting, National Taiwan University, No 1 Sec 4 Roosevelt Road, Taipei 106 Taiwan. pcliao@ntu.edu.tw. * The author would like to thank two anonymous referees for their valuable suggestions and constructive comments. Financial support from the College of Management at National Taiwan University is gratefully acknowledged. 1 Another stream of literature within industrial organisation which deals with R&D spillovers is the study of patent races. 2 Amir (2000) compares the models of AJ and KMZ, and shows that the two models are not quantitatively equivalent in the sense that the AJ model leads to higher R&D levels than the KMZ model. Moreover, the stylised fact that the industry R&D levels are decreasing in the degree of spillovers is confirmed by the KMZ model but not by the AJ model. 3 For extensive literature surveys, see DeBondt (1996), Veugelers (1998) and Kaiser (2002a).