Managing spillovers: An endogenous sunk cost approach

For many real-world markets (such as media, telecommunications, high tech markets, commercial aircrafts, etc.), incurring endogenous sunk costs (in the form of quality enhancing expenditures), in the presence of R&D spillovers, is an essential feature of competition. We study the interaction between these sunk costs and R&D spillovers relying on the Sutton’s concept of endogenous sunk costs and show that with spillovers increasing and the effectiveness of investment in raising quality decreasing, the lower bound on concentration for an industry decreases and ultimately collapses to zero when spillovers are large enough and/or effectiveness of investment is low enough. We also show that for an intermediate range of spillovers firms do invest in R&D although the market structure becomes fragmented as market size grows (no lower bound). In the second part, we allow firms to protect their investment against spillovers and focus on the symmetric equilibria, where all firms either protect their investment or do not protect at all. We show that higher spillovers and/or lower effectiveness of investment may induce firms to protect themselves against spillovers, leading to higher investment in quality, and to more concentrated market structure. Thus, the Sutton’s result on the concentration bound is preserved. JEL Classification: L13, O30