In these essays, I examine the endogenous relationship between market structure and innovation within industries with product markets characterized by horizontal and vertical product differentiation and fixed costs which relate R&D investment and product quality. The theoretical and empirical models build upon Sutton’s (1991, 1997, 1998, 2007) endogenous fixed cost (EFC) framework. In the first essay, I develop an EFC model under asymmetric R&D costs that incorporates an endogenous decision by firms to license or cross-license their technology. In the second essay, I examine whether a specific industry, agricultural biotechnology, is characterized by endogenous fixed costs associated with R&D investment.
The theoretical model presents a more general expression of Sutton’s framework in the sense that Sutton’s results are embedded in the endogenous licensing model when markets are sufficiently small, when transactions costs associated with licensing are sufficiently large, or when patent rights are sufficiently weak. For finitely-sized markets, the presence of multiple research trajectories and fixed transactions costs associated with licensing raises the lower bound to market concentration under licensing relative to the bound in which firms invest along a single R&D trajectory or in which transactions costs associated with licensing are negligible. Moreover, I find that the lower bound to R&D intensity is strictly greater than the lower bound to market concentration under licensing whereas Sutton (1998) finds equivalent lower bounds. This implies a greater level of R&D intensity within industries in which licensing is prevalent as innovating firms are able to recoup more of the sunk costs associated with increased R&D expenditure. Sutton’s (1998) EFC model predicts that as the size of the market increases, existing firms escalate the levels of quality they offer rather than permit additional entry of new firms. This primary result of quality escalation continues to hold when firms are permitted to license their technology to rivals, but low-cost innovators are able to increase the number of licenses to high-cost imitators as market size increases.
Prior to estimating the empirical model, I illustrate the theoretical lower bounds to market concentration implied by an endogenous fixed cost (EFC) model with vertical and horizontal product differentiation and derive the theoretical lower bound to R&D concentration from the same model. Using data on field trial applications of genetically modified (GM) crops, I empirically estimate the lower bound to R&D concentration in the agricultural biotechnology sector. I identify the lower bound to concentration using exogenous variation in market size across time, as adoption rates of GM crops increase, and across agricultural regions.
The empirical estimations imply that the agricultural biotechnology sector is characterized by endogenous fixed costs associated with R&D investments. As firms are able to increase their market shares by increasing the quality of products offered, there are incentives for firms to increase their R&D investments prior to competing in the product market. The lower bound to concentration implies that even as the acreage of GM crops planted increases, one would not expect a corresponding increase in firm entry. However, the results from the estimations for GM soybean seeds indicate that concerns for increased concentration of intellectual property arising from firm mergers and acquisitions may be justified, even though there is little evidence to support this claim from the corn and cotton seed markets.
Regulators and policymakers will find the results of the theoretical and empirical models particularly relevant across a variety of industries. The announcements of license and cross-license agreements between firms within the same industry are often accompanied by concerns of collusion and anti-competitive behavior. Moreover, there have been renewed concerns over concentration in agricultural inputs, and in particular agricultural biotechnology. However, the theoretical model implies that the ability of firms to license their technology increases the highest levels of quality offered by providing additional incentives to R&D for low-cost market leaders. The empirical estimations reveal that the agricultural biotechnology sector is characterized by endogenous fixed costs thus implying a greater level of firm concentration than what would be observed in perfectly competitive or exogenous fixed cost markets.