Standing on the Shoulders of Dwarfs: Dominant Firms and Innovation Incentives

We develop a dynamic innovation model with three important features: (a) asymmetry between large and small firms ("giants" and "dwarfs"); (b) technology transfer by acquisition; and (c) the distinction between radical innovation (compete for the market) and incremental innovation (compete within the market). We provide conditions such that (a) greater asymmetry between giant and dwarfs decreases incremental innovation but increases radical innovation; and (b) allowing for technology transfer increases incremental innovation but decreases radical innovation. These results have several policy implications, including: (a) with weak markets for technology, a soft antitrust policy toward dominant firms leads to an increase in radical innovation but a decrease in incremental innovation; (b) a merger policy that restricts the acquisition of fringe firms by dominant firms leads to lower incremental innovation rates and higher radical innovation rates; (c) the effect of IP protection on innovation is mixed: by increasing the prize from patenting, it increases incremental innovation; but, by improving the market for technology, it reduces the rate of radical innovation.