Monopsony Power and Upstream Innovation

How does a monopsonist incentivize its supplier to innovate? By decreasing the short-run profit of the supplier, the monopsonist can increase the supplier’s incentive to invest in R&D by lessening the supplier’s Arrow’s replacement effect. The monopsonist engages in this practice despite a distortion in its trade volume with the supplier that causes inefficiency. We discuss implications for the boundaries of the firm.