Start-up Acquisitions and the Entrant’s and Incumbent’s Innovation Portfolios

An entrant and an incumbent engage in an investment portfolio problem where each chooses how to allocate its research funds across a rival market, where they compete with one another, and a non-rival market, where they do not interact. Allowing for acquisitions distorts both players’ incentives to allocate funding across their rival and non-rival projects. We show conditions under which the incumbent, anticipating the rents that accrue from the monopolization of the rival market, moves R&D resources from other markets to the rival market. This “incumbency for buyout effect” lowers the expected rents the entrant obtains from the contestable market, which gives it incentives to move its investment portfolio away from the rival market. We show that this strategic effect dominates the usual “innovation for buyout effect” when the entrant’s bargaining power is below a threshold. Allowing for acquisitions may improve the direction of innovation of each of the players as well as consumer surplus. Because precisely the shift of resources towards and away from non-rival projects causes the welfare gains and losses, using the traditional definition-of-the-market approach to assess the impact of acquisitions should be reconsidered.