Privatization and innovation in a vertical structure

Abstract

We investigate how upstream privatization affects downstream R&D investments and social welfare in a vertically-related industry with an upstream monopolistic firm and two downstream firms. One of the downstream firms can undertake R&D investments to reduce input coefficient. We examine two cases: private upstream monopoly versus public upstream monopoly, and show that the presence of a public upstream firm might reduce the downstream firm's motivation to invest in R&D. Compared to upstream nationalization, upstream privatization could lead to higher consumer surplus and social welfare, especially when the R&D process is significantly efficient. We further extend our analysis in three directions to show the implications of technology spillovers, upstream competition and downstream R&D competition. We show that our main results hold with the presence of technology spillovers, and under a successive Cournot oligopoly involving two upstream firms. When there is downstream R&D competition, upstream privatization always hurts consumers and social welfare. Our study yields valuable insights for privatization policies.