Competition and Innovation: An Inverted U Relationship

This paper investigates the relationship between product market com-petition (PMC) and innovation. A Schumpeterian growth model is devel-oped in which …rms innovate ‘step-by-step’, and where both technological leaders and their followers engage in R&D activities. In this model, com-petition may increase the incremental pro…t from innovating; on the other hand, competition may also reduce innovation incentives for laggards. This model generates four main predictions which we test empirically. First, the relationship between product market competition (PMC) and innovation is an inverted U-shape: the escape competition e¤ect dominates for low ini-tial levels of competition, whereas the Schumpeterian e¤ect dominates at higher levels of competition. Second, the equilibrium degree of technologi-cal ‘neck-and-neckness ’ among …rms should decrease with PMC. Third, the higher the average degree of ‘neck-and-neckness ’ in an industry, the steeper the inverted-U relationship between PMC and innovation in that industry. Fourth, …rms may innovate more if subject to higher debt-pressure, espe-cially at lower levels of PMC. We confront these four predictions with a new panel data set on UK …rms ’ patenting activity at the US patenting of-…ce. The inverted U relationship, the neck and neck, and the debt pressure predictions are found to accord well with observed behavior in the data