Downstream R&D, raising rivals\u27 costs, and input price contract

We analyze the incentives for cost-reducing R&D by downstream firms in a two-tier market structure. Downstream R&D increases the demand for an input,thereb y allowing the upstream firm to raise the input price. While it lowers the benefit of R&D to a downstream firm,suc h a price adjustment by the input supplier leads to a higher production cost for all rival firms. Due to this “raising rivals’ cost” effect,a downstream oligopolist may invest more in R&D than does a downstream monopolist,a phenomenon that does not occur in a purely horizontal setting. Fixed-price agreements under which the input price remains unchanged in response to downstream R&D promote innovation by eliminating the opportunistic behavior of the input supplier. In general,the incentive for downstream R&D is positively related to input pricing rigidit