Competition and Innovation: The Inverted-U Relationship Revisited

I re-examine the inverted-U relationship between competition and innovation (originally modeled and tested by Aghion et al. [2005]) by using data from publicly traded manufacturing …rms in the US. I control for the possible endogeneity of competition by using various measures of foreign competition as instruments. I …nd a positive relationship between competition (as measured by the inverse of markups) and innovation (as measured by citation-weighted patents). The positive relationship is robust to many alternative assumptions and speci…cations. To reconcile the positive relationship in the US data with the inverted-U relationship that Aghion et al. [2005] …nd in the UK data, I modify their theoretical model and show that the modi…ed model can explain both positive and inverted-U relationships. The key theoretical assumption is that the US manufacturing industries are technologically more neck-and-neck than their counterparts in the UK. There is some, though not strong, support for this assumption in the data. JEL Classi…cation Codes: L10; O30 Email: [email protected]; Phone: +65-6516-6547; Fax: +65-6775-2646; Webpage: aamirhashmi.com. yI thank Diego Restuccia, Daniel Tre‡er and Johannes Van Biesebroeck for their guidance and Philippe Aghion, Michelle Alexopoulos, Nicholas Bloom, Rachel Gri¢ th, Peter Howitt, Igor Livshits, Angelo Melino, Ivan Png, Carlos Rosell, Shouyong Shi, Xiaodong Zhu and audiences at the University of Toronto, the EEA meeting in Amsterdam, the FAEA meeting in Bali and the IO Reading Group meeting at the National University of Singapore for their comments. Special thanks are due to Rachel Gri¢ th for sharing the data set and the STATA codes used by Aghion et al. [2005].