Competition and Innovation: The Inverted-U Relationship Revisited

Abstract

I re-examine the inverted-U relationship between competition and innovation (originally modeled and tested by Aghion et al. [2005]) by using data from publicly traded manufacturing firms in the US. I control for the possible endogeneity of competition by using various measures of foreign competition as instruments. I find a positive relationship between competition (as measured by the inverse of markups) and innovation (as measured by citation-weighted patents). The positive relationship is robust to many alternative assumptions and specifications. To rec- oncile the positive relationship in the US data with the inverted-U relationship that Aghion et al. [2005] find in the UK data, I modify their theoretical model and show that the modified model can explain both positive and inverted-U relationships. The key theoretical assumption is that the US manufacturing industries are technologically more neck-and-neck than their counterparts in the UK. There is some, though not strong, support for this assumption in the data.