Competition, R&D and innovation: testing the inverted-U in a simultaneous system

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Abstract

To address the relationship between innovation and competition we jointly estimate the opportunity, production, and impact functions of innovation in a simultaneous system. Based on Swiss micro-data, we apply a 3-SLS system estimation. The findings confirm a robust inverted-U relationship, in which a rise in the number of competitors at low levels of initial competition increases the firm’s research effort, but at a diminishing rate, and the research effort ultimately decreases at high levels of competition. When we split the sample by firm types, the inverted-U shape is steeper for creative firms than for adaptive ones. The numerical solution indicates three particular configurations of interest: (i) an uncontested monopoly with low innovation; (ii) low competition with high innovation; and (iii) a ‘no innovation trap’ at very high levels of competition. The distinction between solution (i) and (ii) corresponds to Arrow’s positive effect of competition on innovation, whereas the difference between outcomes (ii) and (iii) captures Schumpeter’s positive effect of market power on innovation. Simulating changes of the exogenous variables, technology potential, demand growth, firm size and exports have a positive impact on innovation, while foreign ownership has a negative effect, and higher appropriability has a positive impact on the number of competitors.

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Fig. 1
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Notes

  1. 1.

    One should not conflate this with his hypothesis of a positive impact of firm size on innovation Schumpeter (1942).

  2. 2.

    See, e.g. Geroski (2003) and the model of Grossman and Shapiro (1987).

  3. 3.

    See, e.g., Loury (1979) or Cellini and Lambertini (2005, 2011).

  4. 4.

    See, e.g. Sutton (1991, 1998).

  5. 5.

    Similarly, we assume that the influence of increasing returns in knowledge creation on the R&D incentives of Eq. 1 is only indirect and depends on their impact on the probability of innovation success.

  6. 6.

    The questionnaires are available in German, Italian, and French.

  7. 7.

    Even though the circular causation invokes a certain time pattern and the data are available in a panel format, we do not apply lagged variables for two reasons. First and foremost, we have no information on the accurate time period required for R&D inputs in 1 year to yield successful innovations in a later year. Second, the type of firm activities shows relatively little variation over time. Third, the panel is highly imbalanced and consequently too many observations would be lost if we only operated with those firms reporting in every period.

  8. 8.

    Hence, we could also use R&D expenditures as a continuous variable instead of firm types. However, we chose the ordinal classification, mainly because it is more robust to data noise and because it better fits the ordinal structure of the two other endogenous variables. When we tested whether the system was also robust to the use of R&D expenditures as a continuous variable, the functional forms were confirmed and significant for each equation.

  9. 9.

    All mentioned categories are exclusive, i.e. each firm has only one value. The identification rules are hierarchical. For example, firms carrying out own innovations in addition to adopting new technology are classified in the higher rank ‘4’. Overall, the firm types aim to combine various qualitative dimensions from the innovation survey (e.g., innovation vs. no innovation; innovations new to the firm vs. those new to the market; or process vs. product innovations) within a new and single variable of genuine meaning (e.g., that of ‘adaptive’ vs. ‘creative entrepreneurship’). For a detailed explanation see Peneder (2010).

  10. 10.

    For lively debates on the use of instrumental variables with respect to causal inference, theoretical priors and randomized controlled experiments, see Pearl (2009), Angrist and Pischke (2010), Leamer (2010) or Deaton (2010).

  11. 11.

    Of related interest, see e.g. Bloch et al. (2012) presenting a dynamic game of position strategies determining the equilibrium number of active firms.

  12. 12.

    Please note that this argument does not imply that increasing innovation is always the best strategy for a firm, since the argument does not include the cost of increased market power. To understand the innovation incentives for a firm, one must again turn to the opportunity function.

  13. 13.

    However, see also the more detailed case-based discussions on antitrust in innovative industries, e.g. by Crandall and Jackson (2011), Owen (2011) or Wright (2011).

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Acknowledgments

This paper has benefitted from critical comments and thoughtful considerations provided at numerous discussions and presentations at conferences or seminars, e.g. at KOF-ETH, WIFO, SPRU, IPTS, IIOC, or ISS. Among these, we are most indebted to Michael Pfaffermayr and Serguei Kaniovski as well as Esben Sloth Andersen, Spyros Arvanitis, Harald Badinger, Harry Bloch, Herbert Dawid, Erik Dietzenbacher, Kurt Dopfer, Giovanni Dosi, Peter Egger, Peter Fleissner, Klaus Gugler, Heinz Hollenstein, Werner Hölzl, Andreas Reinstaller, Manuel Wäckerle, Carl-Christian von Weizsäcker, Ulrich Witt, Christine Zulehner and two anonymous referees. We are also grateful to Eva Sokoll and Astrid Nolte for their invaluable technical assistance.

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Correspondence to Michael Peneder.

Appendices

Annex 1: Reduced form solution

We can also solve the system of Eqs. 1 to 3 in reduced form. For the sake of simplicity, we omit the subscripts for firms i when substituting Eq. 1 in Eq. 2:

$$I=\alpha_2 +\beta_2 \left( {\alpha_1 +\beta_1 C+\theta C^2+\gamma_1 X+\delta_1 O_j} \right)+\gamma_2 X+\delta_2 M_j $$

By substitution in Eq. 3, we get the following reduced form for the number of competitors:

$$\begin{array}{rll} C&=&\alpha_3 +\beta_3 \left[ {\alpha_2 +\beta_2 \left( {\alpha_1 +\beta _1 C+\theta C^2+\gamma_1 X+\delta_1 O_j} \right)+\gamma_2 X+\delta_2 M_j} \right]\\ &&+\gamma_3 X+\delta_3 A_j \end{array} $$

Multiplication of terms yields:

$$\begin{array}{rll} C&=&\alpha_3 +\alpha_2 \beta_3 +\alpha_1 \beta_2 \beta_3 +\beta_1\beta_2 \beta_3 C+\beta_2 \beta_3 \theta C^2+\beta_2 \beta_3 \gamma_1 X \\ &&+\beta_2 \beta_3 \delta_1 O_j +\beta_3 \gamma_2 X+\beta_3 \delta_2 M_j +\gamma_3 X+\delta_3 A_j \end{array} $$

Some rearrangement leads to the following expression of a quadratic function:

$$\begin{array}{l} \beta_2 \beta_3 \theta C^2+\left( {\beta_1 \beta_2 \beta_3 -1} \right)C+\beta_2 \beta_3 \gamma_1 X+\beta_3 \gamma_2 X+\gamma_3 X+\beta_2 \beta_3 \delta_1 O_j \\ \quad +\beta_3 \delta_2 M_j +\delta_3 A_j+\alpha_1 \beta_2 \beta_3 +\alpha _2 \beta_3 +\alpha_3 =0 \end{array} $$

We thus have a quadratic system \(\alpha C^{2} + bC + c = 0\), which can be solved by

$$C_{1,2} =\frac{-b\pm \sqrt {b^2-4\alpha c}} {2\alpha} $$

for \(a =\beta _{2}\beta _{3}\theta , b = (\beta _{1}\beta _{2}\beta _{3}-1)\), and \(c=\alpha _1 \beta _2 \beta _3 +\alpha _2 \beta _3 +\alpha _3 +\beta _2 \beta _3 \gamma _1 X+\beta _3 \gamma _2 X+\gamma _3 X+\beta _2 \beta _3 \delta _1 O_j +\beta _3 \delta _2 M_j +\delta _3 A_j \), and provided \(b^{2}-4\alpha c\ge 0\).

Substituting Eq. 2 directly into Eq. 3, we get the following expression relating research effort E to the number of competitors C:

$$\begin{array}{rll} C&=&\alpha_3 +\beta_3 \left( {\alpha_2 +\beta_2 E+\gamma_2 X+\delta_2 M_j} \right)+\gamma_3 X+\delta_3 A_j \\ C&=&\beta_2 \beta_3 E+\alpha_3 +\alpha_2 \beta_3 +\beta_3 \gamma_2 X+\gamma_3 X+\beta_3 \delta_2 M_j +\delta_3 A_j \\ \beta_2 \beta_3 E&=&C-\left( {\alpha_3 +\alpha_2 \beta_3 +\beta _3 \gamma_2 X+\gamma_3 X+\beta_3 \delta_2 M_j +\delta_3 A_j}\right)=C-Intercept\\ E&=&\frac{C-Intercept}{\beta_2 \beta_3} \end{array} $$

Annex 2: Supplementary tables

Tables 8, 9, 10 and 11

Table 8 Number of firms by industry and year
Table 9 3 SLS estimations with time-varying instruments (standard errors in brackets)
Table 10 3 SLS estimations with \(\mathbf {C_i^{squared}}\) also instrumented (standard errors in brackets)
Table 11 Reduced form \(\mathbf {C_i^{squared}}\) (standard errors in brackets)

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Peneder, M., Woerter, M. Competition, R&D and innovation: testing the inverted-U in a simultaneous system. J Evol Econ 24, 653–687 (2014). https://doi.org/10.1007/s00191-013-0310-z

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Keywords

  • Innovation
  • Competition
  • Inverted-U
  • Technological regimes
  • Simultaneous system
  • 3-SLS estimation

JEL Codes

  • L11
  • L22
  • L41
  • M13
  • O33