This paper investigates the relationship between product market competition and innovation. We find strong evidence of an inverted-U relationship using panel data. We develop a model where competition discourages laggard firms from innovating but encourages neck-and-neck firms to innovate. Together with the effect of competition on the equilibrium industry structure, these generate an inverted-U. Two additional predictions of the model—that the average technologi- cal distance between leaders and followers increases with competition, and that the inverted-U is steeper when industries are more neck-and-neck—are both supported by the data.
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