Reexamining the effect of the most-favored-nation provision in input prices on R and D incentives

We examine the effect of the most-favored-nation provision in input prices on downstream firms' R and D incentives. Contrary to the previous literature, we show that the effect depends on the extent of substitutability between downstream firms if they compete in two-part tariffs. When a downstream firm lowers its marginal cost, it entails two conflicting effects on the upstream firm's pricing for inputs, the standard elasticity effect of penalizing the low-cost firm and the market share effect of rewarding it. If substitutability between downstream products is high enough, the latter dominates the former, and thus downstream firms will choose a higher marginal cost technology under the MFN provision.