Upstream regulation and non-separable innovation

The goal of this paper is to study the impact of input regulation on non-separable innovation in vertically related industries. For this purpose, we consider a setting where a vertically integrated upstream monopolist, who supplies the essential input to its downstream competitor at linear regulated prices, chooses its innovation level without being able to separate between process and product innovation. We find that when the overall upstream innovation activity results in more (less) product than process innovation, less stringent input price regulation decreases (increases) the level of innovation activity. Since more light regulation implies lower input prices intensifying downstream competition, the “Schumpeterian” (“escape competition”) effect dominates when product (process) innovation prevails. We show that this finding arises because the vertically integrated firm strategically sets its innovation level to mitigate the negative impact of an input price reduction on its profit. We draw significant managerial and policy implications concerning regulated vertically integrated industries, such as telecommunications and energy. In this direction, we also shape the mechanisms that foster innovation without much affecting the intensity of downstream competition.