Small Steps or Giant Leaps? Competition and the Size of Innovations

Abstract:

Does an increase in competition incentivize firms to aim higher or does it shift their R&D strategies towards less risky and more incremental innovation? In a duopoly model I find that more intense competition draws firms' R&D strategies from drastic innovation towards smaller steps. This effect is compatible with an inverted-U relationship between competition and total innovation and the result implies that the level of competition at which the absolute amount of large innovation in the economy is maximized is lower than the level which maximizes overall innovation.

In a first empirical test of these predictions the study takes advantage of an instrument for Chinese import competition to establish causality and quantifies the type of innovation applying machine learning methods for textual analysis to patent abstracts to create new measures for the type of innovation. I find evidence for a decline in the share of large innovations as competition increases. These results imply a competition policy tradeoff between incentives for R&D and the distortion towards small steps if the externalities of large innovations are higher.