Preemptive R&D, Rent Dissipation, and the "Leverage Theory"

This paper provides a new perspective on the validity of the so-called 'leverage theory'. In a model of preemptive innovation in 'systems' markets, 1 examine the effect of bundling on R&D incentives. 1 find that bundling provides a channel through which monopoly 'slack' in one component market can be shifted to another, with the effect of mitigating rent dissipation in the systems market. Bundling can be profitable if this beneficial effect of reduced rent dissipation outweighs the negative effect of intensified price competition. After demonstrating the private optimality of bundling, its welfare implications are considered. There is a discrepancy between the market outcome and the socially optimal outcome which can be explained in terms of externalities conferred on consumers' surplus and the rival firm's profits due to bundling. Finally, the results can be reinterpreted to analyze the relationship between compatibility decisions and R&D incentives in mix-and-match models.