Managing spillovers: An endogenous sunk cost approach

Abstract

We introduce spillover e¤ect into John Sutton's (1991,1998) concept of endogenous sunk costs. These sunk costs appear in the form of R&D investment into quality in our framework. We show that with spillovers increasing and the e¤ectiveness of investment in raising quality decreasing, the Sutton lower bound on concentration for an industry decreases and ultimately collapses to zero when spillovers are large enough and/or e¤ectiveness of investment in raising quality is low enough. In the second part, we allow …rms to protect their investment against spillovers We focus on symmetric pure strategy Nash equilibria, where all …rms either protect their investment or do not protect at all. Contrary to the result with exogenous spillovers assumed in the …rst part, in the second part of the paper we show that higher ex ante spillovers and/or lower e¤ectiveness of investment in raising quality may induce …rms 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, if we allow …rms to manage spillovers via private protection.