Buying from a competitor: a model of knowledge spillover and innovation

Many firms buy a production input from a competitor. However, managers often worry that this supply relationship may give their competitor valuable knowledge about new product innovations. We develop a two-period model in which a firm can buy an input from a competitor or a third party in each period. In order to innovate, the firm must invest in improving the input, which results in its supplier learning to produce a higher quality input. We show that buying from the competitor: (i) increases short-term profits by softening price competition and (ii) may reduce long-term profits by preventing investment in innovation. Our results imply that the classic holdup problem, which leads to underinvestment in innovation, becomes more severe when a firm buys from its competitor who benefits from knowledge spillover.