Critics of Microsoft and Google's dominance claim these companies are
nothing but "giants standing on the shoulders of babies,"
whose dominance destroys the incentives for entrants to innovate. By
contrast, pro-Microsoft and pro-Google analysts stress the benefits of
large, innovative firms. We analyze the validity of these competing
claims in a model of R&D and product market competition between a
dominant firm and a small rival. An increase in firm dominance, which we
measure by a premium in consumer valuation, increases the dominant
firm's incentives but decreases the rival firm's incentives for R&D.
We provide sufficient conditions such that the positive effect on the
dominant firm is mostly infra-marginal, whereas the negative effect on
the rival firm is mostly marginal. As a result, the R&D
encouragement effect is lower than the R&D discouragement effect;
and if innovation is sufficiently important then firm dominance also
decreases consumer and social surplus. We also provide conditions such
that an increase in firm dominance increases the probability of
innovation, essentially because the transfer of innovation incentives
form the rival firm to the dominant firm reduces the probability of
duplicative R&D efforts