International Competition, Growth, and Optimal R&D Subsidies∗

In this paper I examine the effects of international technological competition on inno-vation, growth, and optimal R&D subsidies. I focus on a particular dimension of com-petition: the share of industries where domestic and foreign research firms compete for innovation. In a version of the fully-endogenous quality-ladder growth model I show that the effect of competition on innovation and growth depends on the specification of the research technology. Secondly, I find that increases in foreign competition trigger a business-stealing effect that reduces income and welfare and, regardless of the innovation effect, raises the optimal domestic R&D subsidy. Intuitively, the higher the threat of international competition the more instrumental innovation subsidies will be in helping domestic incumbent firms to retain their shares of the global market. Thirdly, I perform a quantitative exercise: I first build an empirical index of international technological com-petition and find that in the OECD countries the share of competitive sectors increased from 35 percent in 1973 to 70 percent in 1989. Then, I use this evidence to evaluate the optimality of the U.S. R&D subsidy response to observed competition in that period.