When two competitors merge, regulators must weigh many factors: Will consumers pay higher prices? Will efficiency gains be passed on? In recent years, the impact of consolidation on research and development (R&D) has also become a crucial concern for policymakers and researchers, including those at TSE Competition Policy & Regulation Center. In a paper forthcoming in the RAND Journal of Economics, Bruno Jullien and Yassine Lefouili examine how mergers between competing firms affect their incentives to invest in innovation.
Why study the relationship between mergers and R&D?
Innovation is one of the main engines of productivity growth and improvements in consumer welfare. It can both reduce costs and boost demand. For example, a smartphone maker might streamline production by investing in automation or seek to attract more customers by offering sharper cameras.
Mergers between competing firms can change their incentives to invest in such improvements. Authorities in Europe and the US now routinely examine how consolidation affects investment in R&D. Yet assessing this effect is not easy.
Existing research offers conflicting results on the effects of horizontal mergers on R&D investments. We set out to gain a clearer picture with a broader framework that disentangles the various effects at play. To do this, our paper focuses on incremental innovation that can affect the cost and/or the demand of an existing product.
How do ‘diversion ratios’ help to assess mergers?
Imagine two supermarkets competing in the same market. Each firm has an incentive to cut prices to lure shoppers from the other. This incentive weakens if the supermarkets become one merged entity. The price diversion ratio – which measures the percentage of a product’s sales lost to a rival after a unilateral price rise – is often used by competition authorities to quantify the degree of substitutability between firms’ products. A high ratio indicates that competing products are close substitutes, and that a merger would likely raise prices.
Innovation diversion is a similar concept, focusing on the impact of a firm’s innovation on a rival’s demand. Competing firms have strong incentives to invest in innovation, since winning an edge – with lower costs or better products – will take business away from rivals. The innovation diversion ratio informs us about the intensity of this rivalry. A higher ratio indicates a stronger incentive to reduce innovation after a merger.
However, looking at these ratios separately is not sufficient to draw conclusions about the likely effect of a merger on innovation incentives. This is because innovation and price effects interact in complex ways. For instance, higher prices may increase incentives to raise demand through innovation, but they may also weaken incentives to invest in cost-reducing innovation.
In our paper, we show that the comparison of the price diversion ratio and the innovation diversion ratio may help to assess the net effect of a merger on innovation.
When do mergers reduce innovation?
Our analysis suggests that incentives to invest in demand-enhancing innovation will be reduced by a merger if the innovation diversion ratio is higher than the price diversion ratio. However, our model also highlights different conditions under which a merger can have a positive impact on R&D investment. To establish these results, we break down the various forces at work including those arising from market power and those related to externalities between firms.
What are the policy implications?
As mentioned earlier, comparing the two diversion ratios can help competition authorities screen mergers. If the innovation diversion ratio is higher, the merger is likely to reduce innovation, absent synergies. However, if the price diversion ratio is higher, a merger may raise incentives to innovate even without synergies.
While our findings indicate there may be a trade-off between a merger’s impact on incremental innovation and on prices, our simulations suggest that a merger between competitors is likely to be harmful to consumers if there are no spillovers or synergies in production and R&D.
KEY TAKEAWAYS
Mixed effects – Mergers can either encourage or discourage investment in R&D.
Screening tool – Comparing the price and innovation diversion ratios helps competition authorities predict when a merger might harm innovation.
Valuable insight – When the innovation diversion ratio exceeds the price diversion ratio, mergers are likely to reduce demand-enhancing innovation.
What about consumers? – In an industry where innovation is incremental, a merger between competitors is likely to harm consumers in the absence of spillovers and synergies.
FURTHER READING
TSE Competition Policy & Regulation Center promotes policy-relevant research on topics of interest to regulatory authorities including the effects of mergers, agreements, and unilateral practices on competition and welfare. This research paper – Horizontal Mergers and Incremental Innovation – is coauthored by Marc Bourreau. Other publications by Bruno and Yassine are available to read on the TSE website.
Article published in TSE Reflect, September 2025
