Product Innovation with Vertical Differentiation: Is a Monopolist's Incentive Weaker?

Extant literature shows that Arrow’s famous result—a secure monopolist gains less from a nondrastic process innovation than would a competitive firm—does not always extend to nondrastic product innovations. If the new product is horizontally differentiated, the monopolist can have a greater incentive to add the new product than a firm that would face competition from the old product; but the monopolist’s incentive to add the new product cannot be greater if the new product is vertically differentiated with higher quality than the old. This paper compares the incentives when the new product is vertically differentiated but of lower quality, a common case empirically. We show that, as with horizontal differentiation, the monopolist can have the greatest incentive to add the new product. However, in all the cases analyzed, consumer welfare (though not total welfare) is lower under monopoly, even when only the monopolist would add the new product. Our analysis also helps clarify why the ranking of incentives depends on the type of product differentiation and on whether the market is covered or not.