Impact of cost-reducing R&D spillovers on the ergodic distribution of market structures

The analysis of R&D spillovers between firms has been largely restricted to static two-stage models (R&D decisions followed by product market decisions). Such models are silent on the relationship between spillovers and concentration. We present a dynamic duopoly model of R&D with spillovers where industry concentration is endogenous. In our model, firms compete repeatedly in both the product market via Cournot competition and in imperfectly appropriable process R&D. The analysis highlights previously ignored welfare effects of spillovers through dynamic changes in industry concentration. In addition, the impact of imperfect appropriability of R&D on concentration and welfare depends crucially on the manner in which spillovers are obtained. We find that when spillovers require absorptive capacity investment in own R&D, larger spillovers lead to declines in concentration while rates of innovation increase and welfare rises. In contrast, when spillovers are costlessly obtained the effect on concentration depends on the extent of spillovers. At low levels of spillovers, concentration declines because larger firms reduce R&D more than small firms. While at high levels of spillovers, small firms free ride leaving larger firms with higher rates of innovation leading to increased concentration. However, welfare unambiguously declines through both reduced consumer surplus and firm values.