Competition and Innovation: An Inverted-U Relationship

This paper investigates the relationship between product market competition (PMC) and innovation. A growth model is developed in which competition may increase the incremental profit from innovating; on the other hand, competition may also reduce innovation incentives for laggards. There are four key predictions. First, the relationship between product market competition (PMC) and innovation is an inverted U-shape. Second, the equilibrium degree of technological ‘neck-and-neckness’ among firms should decrease with PMC. Third, the higher the average degree of ‘neck-andneckness’ in an industry, the steeper the inverted-U relationship. Fourth, firms may innovate more if subject to higher debt-pressure, especially at lower levels of PMC. We confront these predictions with data on UK firms’ patenting activity at the US patenting office. They are found to accord well with observed behavior. ∗Acknowledgement: The authors would like to thank Daron Acemoglu, Tim Bresnahan, Wendy Carlin, Paul David, Janice Eberly, Dennis Ranque, Robert Solow, Manuel Trajtenberg, Alwyn Young, John Van Reenen and participants at CIAR, Harvard and MIT. Financial support for this project was provided by the ESRC Centre for the Microeconomic Analysis of Fiscal Policy at the IFS. The data was developed with funding from the Leverhulme Trust. †Harvard University and University College London ([email protected]) ‡Institute for Fiscal Studies and University College London ([email protected], [email protected], [email protected]) §Brown University ([email protected])