Competition and Innovation: An Inverted U Relationship

Competition and Innovation: An Inverted U Relationship Philippe Aghion (Harvard & UCL) Nick Bloom (CEP, LSE) Richard Blundell (IFS & UCL) Rachel Griffith (IFS & UCL) Peter Howitt (Brown) “Competition and Innovation Workshop”, 23rd September 2003

Motivation and summary of the paper Model Empirical results Policy implications

Competition policy is evolving rapidly • Policy concern in UK and Europe that productivity levels and growth rates are low, and that this is due to the lack of product market competition • UK and EU strengthening competition regimes “The Government has placed competition policy at the heart of its strategy to close the productivity gap.” UK Pre-Budget Report November 2001 • US already has powerful competition policy which even permits imprisoning company directors • What is the theoretical and empirical evidence basis for these policies?

Evidence from conventional wisdom, theory and empirics on the impact of competition appears contradictory • Conventional wisdom provides mixed views “Competition effect”: “... from Adam Smith to Richard Caves: the belief that competition is good, rests on the idea that competition exerts downward pressure on costs, reduces slack and provides incentives for efficient organisation of production...” (Nickell, 1996 JPE) “Schumpeterian effect”: “....anti-trust discourages innovation.......” (Bill Gates and lawyers, frequently) • Economic theory often supports the Schumpeterian effect of a negative competition effect on innovation • Empirical work, however, typically supports finds a positive effect – i.e. Geroski (1995 OUP), Nickell (1996 JPE) and Blundell, Griffith and Van Reenen (1999 RES), Mohen and ten Raa (2002, WP)

We model both the competition and Schumpeterian effects and estimate the shape of the competition innovation relationship • In our model: • At low levels of competition the “competition effect” dominates leading to a positive relationship • At high levels of competition the “Schumpeterian effect” dominates leading to a negative effect • Overall this leads to an inverted U-shape relationship • We estimate this model on a panel of 460 firms over 20 years and find a robust inverted U-shape between competition and innovation (patenting) high Innovation low low high Competition

We develop a stylised model of competition, innovation and growth across multiple industries • The economy contains many industries, with (for simplicity) two firms, which are either: • “neck-and-neck” as firms have the same technology • “leader-follower” as firms have different technologies • Under low competition “neck-and-neck” firms earn moderate profits, yielding little gain from innovation, so • “neck-and-neck” firms undertake little innovation • leading to an equilibrium with mainly “neck-and-neck” industries • so increasing competition raises innovation as “neck-and-neck” firms increase innovation to “escape competition” • Under high competition “neck-and-neck” profits are low, so the rewards to innovating to become a leader are high, so: • “neck-and-neck” firms undertake a lot of innovation • leading to an equilibrium with mainly “leader-follower” industries • so further increases in competition lower the profits for followers to innovate and become “neck-and-neck”, reducing innovation through a “Schumpeterian effect” • This generates an inverted-U as competition first increases then reduces innovation

Model Predictions The model provides three empirical predictions high • This higher the share of “neck-and-neck” industries the more positive the effect of competition • The share of “neck-and-neck” industries will decline as competition increases Share of neck-&-neck industries low low high Competition high Innovation • Innovation and competition will have an inverted U-shape relationship low low high Competition

We use UK firm level accounting data • Basic data is UK firm level accounting data 1968-94 including all stock market listed firms • Measure innovation by matching patent data from US Patent Office • Sample of 461 firms randomly selected firms matched to patents data • Matched subsidiary names by hand – painful but much higher accuracy • Weighted patents by citations received to measure innovation “quality” • Also confirm results using an R&D measure of innovation • Final Data set has • 330 firms, 4500 observations over 1971-1994 • 236 patenting firms, 60,000 patents, 200,000 citations • Bloom and Van Reenen (2001, EJ) use this data set and demonstrated patents play a powerful role determining market value and productivity.

Measuring Product Market Competition • Traditional measures based on market share • But problem defining the product & location market. • For the UK international markets important – i.e. Glaxo has 7% global market but 70% share of UK market as defined by sales of UK listed firms • So we use the Lerner Index and assume MC AC • Mean of (1-L) is 0.915, min is 0.794, max is 0.976 • Following Griffith (2001) we also cross check this measure using changes in competition following the 1992 Single Market Program, major privatisations and Monopolies and Merger Commission remedies, and found a significant positive correlation

Flexible estimation of the competition innovation relationship (1) - using Kernels • Want to estimate a robust innovation estimator imposing as little structure as possible • A flexible Kernel estimator (a local ‘moving average’) is a natural place to start • Kernel estimation shows an underlying inverted U-shape relationship (see below) high Patents low low high Competition

Flexible estimation of the competition innovation Relationship (2) - using splines and quadratics • Also want to condition on other variables so move to semi-parametric model • Estimate the key moment condition E[P|C] = exp(g(C)) • P is the patent count, C the competition measure, and g(.) a flexible function • We use an exponential `Poisson style’ model because patent counts are skewed with many zeros • g(.) is non-parametrically approximated using a quadratic spline-function (see Ai and Chen, 2002 Econometrica) • the variance-covariance matrix is non-parametrically approximated using a White’s (1982, Econometrica) asymptotic estimator • To allow for industry and time variables effects these are parametrically included in addition to yield a final estimating equation E[Pit|Cit] = exp(g(Cit) + Xit’b) • The spline estimation shows a strong inverted U-relationship • This is closely approximated by a more parsimonious quadratic approximation

Exponential quadratic with year and industry dummies Each point is an industry year observation, indicating most industries are clustered around the peak innovation level high Patents Outer feint lines provide the point-wise 95% confidence interval low low high Competition

Dealing with endogeneity of competition • PMC may be endogenous as higher patenting firms may gain higher rents • Firstly, we include time and industry dummies to remove much of the spurious correlation between competition and innovation • changes in competition identify changes in patenting • Secondly, we instrument changes in competition using the large number of competition changes that have occurred in the UK since 1970: • Differential changes in competition across industries following the 1992 EU single market program • Changes in competition following major privatisations • Change in completion following structural and behavioural remedies imposed on industries after a Monopolies and Mergers Commission

Exponential quadratic with year and industry dummies after controlling for endogeneity high Patents low low high Competition

We also estimation our predictions on the average technological distance from the industry frontier • Define frontier as highest TFP firm • For each firm measure distance from frontier as: • Use industry averages • As predicted, average distance increases as competition rises – indicating industries are becoming less “neck-and-neck” and more “leader-follower” type high Average distance to frontier Kernel estimator of the average distance competition relationship low low high Competition

“Neck-and-Neck” industries also show a steeper inverted U-shape as predicted More “neck and neck” firms with more positive competition effect high Average distance to frontier Less “neck and neck” firms with less positive competition effect low low high Competition

Competition policy implications • In industries with low or moderate levels of competition increasing competition is unambiguously good • Positive impact on innovation as predicted by inverse-U shaped curve • Additional benefits from price reductions through reducing the size of the monopolistic deadweight loss triangle • Low or moderate competition could indicated by • High average industry price-cost markups • Industries with firms with similar product or process technologies • U-shape suggests greatest gain from focusing on industries with lowest levels of competition • At higher levels of competition policy is less obvious – results suggests reducing competition, but • Positive competition effects on price • Distributional effects due to reallocation of welfare from firms to consumers

Competition and Innovation: An Inverted U Relationship