Competition as a Discovery Procedure: Hayek in a Model of Innovation

I model a mechanism through which competition can encourage innovation and growth. Although the oft-cited ‘Schumpeterian effect’ of competition is to decrease the expected rents from an innovation, the competitive process also causes a ‘thousand flowers to bloom’, and provides a mechanism for discovering the best among them. When firms are uncertain about the best direction in which to innovate, more competition implies more innovations, resulting in a higher expected value for the ‘best’ innovation. By endogenizing the level of competition and introducing this uncertainty into a general equilibrium model of vertical innovation, I show how this Hayekian effect of competition can work against the Schumpeterian effect, resulting simultaneously in a positive relationship between competition and growth at the industry level, and an inverted-U relationship between competition and firm-level innovation. Finally, I show how this framework can be used to examine the effects on innovation of antitrust policy and regulation.