Innovation Perspectives:Schumpeter V Arrow

Market competition and innovation

Studies on market competition and firms’ innovative activities have a long history. It has been known as the Schumpeter/Arrow debate.

Schumpeter versus Arrow

The so-called Schumpeterian argument states that market concentration, i.e. lack of competition, is beneficial to innovation activities. Based on Schumpeter’s (1934 – 1942) views on the necessity of high profit levels and large internal R&D resources it has argued that concentrated markets provide an innovative environment. Schumpeter argued that more monopolistic firms can more readily perform R&D activities because they face less market uncertainty and have larger and more stable funds.

The counter-argument is based on the finding of Arrow (1962) and has been generalized as stating that competitive environment spurs innovation. According to the Arrowian argument the monopolist has the possibility to slack and no need to innovate.

Theoretical studies

In the late 1970s and 1980s, Louly (1979) and Dasgupta and Stiglitz (1980) studied the effects of market competition on innovative activity using game theory. They showed that firms in competitive markets are more likely to over-invest in R&D. On the other hand Gilbert and Newbery (1982) showed that firms which dominate a product market have an incentive to innovate in order to maintain their monopolistic position. And in the 1990s, Grossman and Helpman (1991) and Aghion and Howitt (1998) constructed growth models where competition in innovative activity is endogenized. These growth models support the Schumpeterian hypothesis that more monopolistic firms are likely to be more innovative.

Empirical studies

The above theoretical developments with regard to R&D activities stimulated a wave of empirical studies in the 1990s. Nickell (1996) studied the effect of market structure on TFP (Total Factor Productivity) by using U.K. firm level data from 1972 to 1986. By estimating a production function that includes independent variables representing market structure, he showed that market competition promoted the productivity growth of firms. Nickell, Nicolitsas, and Dryden (1997), in addition to the impact of market competition, also examined the effects of corporate governance such as the pressure from financial intermediaries and effects of shareholders on managers’ efforts to innovate. Their results showed that not only market competition but also financial pressure has a positive impact on the productivity growth of firms. Blundell, Griffith, and Van Reenen (1999) used count data on innovation and patent data instead of TFP growth as the dependent variable. Their estimation results showed that market share has a positive impact on firms’ innovative activities, although the concentration ratio has a negative impact. In addition, their results suggest that cash flow does not affect innovative activities. These empirical results obtained in the 1990s supported the idea that market competition stimulates innovative activity and hence contradicted the theoretical prediction of the Schumpeterian growth model proposed by Aghion and Howitt (1998).

Further theory development

Aghion et al. (2002) and Aghion and Griffith (2005) therefore developed a new model which explains both the Schumpeterian hypothesis and the positive effect of market competition on innovative activity. They assumed that firms in the intermediate goods market can produce different types of intermediate goods. These firms are categorized into two types. One type of firm belongs to a sector in which firms compete neck-and-neck and the technological gap between competing firms is small. In this sector, firms have an incentive to conduct innovation to escape from competition. On the other hand, other firms that are far from the technology frontier have little incentive to innovate, because the rents such firms derive from innovation are small. In this case, the Schumpeterian effect works. Overall, Aghion et al. (2002) and Aghion and Griffith (2005) showed that the relationship between competition and innovative activity can be described by an inverted U-shaped curve. In other words, increased competition increases the incentive to innovate when competition is not intense. However, if competition level is high, increased competition leads to reducing the reward of innovation and it also reduces the incentive to innovate. Thus, the relationship between product market competition, when measured as the price-cost margin (e.g. by means of Lerner index) or market concentration, depends on the characteristics of different markets, see also Gilbert (2005).

Michael Mandell

Mandel of the Progressive Policy Institute (2011) says that in the current economy it favors big companies over smaller ones for three reasons

• Economic growth is driven by eco-systems such as the ones that cluster around Google and Apple. They manage the core systems and their skills provide technical leadership
• Globalization puts a premium on size. It is no longer good enough to be big by American standards, you need to be a global player
• The major probles facing the world are global and cannot be resolved on a national basis. Global Warmiong, health care etc.

The implications for policy makes are these

• Western governments have been promoting small companies through incentive and the tax system instead of creating national champions
• Anti-trust legislation has focused on preventing concentrating such as AT&T's failed attempt to take over T-Mobile even if one large company is going to be more innovative than two smaller ones.

What are we to make of these arguments. Google and Facebook were once smaller start-ups and one wonders why Mircrosoft or other large IT companies could not come up with that level of innovation. But American companies with more than 5,000 workers spend more per head than smaller companies and they have an advanatage in being able to recruit brighter students. Large companies are trying to least think small while using their gloabl reach and economies of scale.

Large companies do seem better at incremental innovation but less good at Disruptive Technologies like the ones like Google provided. What is more important than big or small is whether they are high growth companies. 1% of companies create 40% of all new jobs in the US. The focus should be on allowing small companies the opprtunity to grow larger. Large companies tend to be good lobbying for incentives that gobble subsiies and crowd out more productive investment.

Conclusion

To sum up, the empirical evidence on this debate has been ambiguous and recently economists have come to the conclusion that the relationship between competition and innovation most likely is not straightforward. It is imperative that we do understand this relationship as it serves as the basis for policy measures governments should or should not take.

Commentary

One conclusion is that governments should be promoting and supporting innovation of private enterprises rather than be directly involved in the creation of the innovation itself. Before we conclude that question we should take a step back and determine why we need global innovation and why some firms and industries are good at innovation while some are not. From there we might be able to determine where governments can help spur innovation and avoid ‘crowding out’ innovation by deterring companies from innovating themselves. One benefit of innovation is that it is a competitive advantage that can generate new jobs and, as such, is an alternative to low wages as a competitive advantage (which means wages can be higher so long as it does not take a form of higher profits instead).

If innovation can be positive in a globalized economy through increased employment and higher wages then are different ways governments can get involved.

• 1. Promoting a free market or more protectionist economy. A free market can be a spur to innovation. Alternatively, a Schumpterian view would be that market protection would give companies more confidence and higher profits to plough in to innovative R&D. What is important here is not that the government chooses one or the other but understands the relationship between competition and innovation on different industries before making policy decisions.
• 2. High barriers to entry. Some industries would not get established without the influence of government aid or incentives. These could ultimately provide a spur to competition (Airbus) or new industries like nuclear fusion funded by the EU and other governments (JET and latterly ITER)
• 3. Socially desirable innovation. Some industries would not come into existence without the influence of government because there is no consumer demand or the production cost is higher than a less socially desirable alternative. E.g. Green technology including electric cars, more fuel efficient cars, wind farms, etc.
• 4. At a national or international level. British universities have been the recipient of grants from government for research and development. At an international level governments have invested in international projects such as the Hadron Collider.

These examples tend to show that governments can play a role as a catalyst for innovation in new industries or in socially desirable innovations through public and private enterprises but less of a role where there is an established market and history of innovation where it could hinder further innovation by firms.

Sources and further reading

• Aghion, P., Bloom, N., Blundell, R., Griffith, R., Howitt, P. (2002), Competition and Innovation: An Inverted U Relationship, NBER Working Papers 9269.
• Aghion, P., Blundell, R., Griffith, R., Howitt, P., Plantl, S. (2006), The Effects of Entry on Incumbent Innovation and Productivity, NBER Working Papers No.12027.
• Aghion, P., Burgess, R., Redding, S., Zilibotti, F. (2003), The Unequal Effects of Liberalization: Theory and Evidence from India, mimeo.
• Aghion, P., Griffith, R. (2005), Competition and Growth: Reconciling Theory and Evidence, Cambridge, Mass.: MIT Press.
• Aghion, P., Howitt, P. (1998), Endogenous Growth Theory, Cambridge, Mass.: MIT Press.
• Arrow, K. (1962), Economic welfare and the allocation of resources for invention, in: Nelson, R. (Ed.), The Rate and Direction of Inventive Activity, Princeton University Press, 1962, pp. 609-25.
• Blundell, R., Griffith, R., van Reenen, J. (1999), Market Share, Market Value and Innovation in a Panel of British Manufacturing Firms, Review of Economic Studies 66(3): 529554.
• Dasgupta, P., Stiglitz, J. (1980), Industrial Structure and the Nature of Innovative Activity, The Economic Journal, 90: 266293.
• Geroski, P. (1990), Innovation, Technological Opportunity, and Market Structure, Oxford Economic Papers, 42(3): 586602.
• Gilbert, R. (2005), Looking for Mr. Schumpeter: where are we in the competition-innovation debate ?, In: Jaffe, A.B., Lerner, J., Stern, S. (eds), Innovation policy and the economy, Vol. 6. MIT Press.
• Gilbert, R., Newbery, D. (1982), Preemptive Patenting and the Persistence of Monopoly, American Economic Review, 72(3): 514526.
• Grossman, G., Helpman, E. (1991), Innovation and Growth in the Global Economy, Cambridge, Mass.: MIT Press.
• Kawakami, A., Miyagawa, T. (2008), Do Competitive Markets Stimulate Innovation? An Empirical Analysis Based on Japanese Manufacturing Industry Data March, RIETI Discussion Paper Series 08E012. (basis for this post)
• Louly, G. (1979), Market Structure and Innovation, Quarterly Journal of Economics, 93(3):395410.
• Nickell, S. (1996), Competition and Corporate Performance, Journal of Political Economy 104(4): 724-746.
• Nickell, S., Nicolitsas, D., Dryden, N. (1997), What makes firms perform well?” European Economic Review, 41(35):783-796.

A summary of several empirical studies before the 1990s examining the Schumpeterian hypothesis is provided by Scherer, F. (1984), Innovation and Growth, Cambridge, Mass.: MIT Press.

• Schumpeter, J. (1934), The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle, Cambridge, Mass.: Harvard University Press.
• Schumpeter, J. (1942), Capitalism, socialism and democracy, Allan and Unwin, London.
• Tingvall, P., Poldahl, A. (2007), Is There Really an Inverted U shaped Relation Between Competition and R&D ?, EIJS Working Papers Series 0207, The European Institute of Japanese Studies, Stockholm School of Economics.

A summary of gametheoretic approaches to R&D activities is provided in chapter 10 of Tirole, J. (1988), The Theory of Industrial Organization, Cambridge, Mass.: MIT Press.