Wednesday, July 28, 2021
This paper studies the effect of competition on firm innovation by developing a discrete-time endogenous growth model where multi-product firms do two types of innovation subject to friction in technology spillovers. Firms improve their existing products through internal innovation while entering others' product markets through external innovation. We introduce novel friction termed imperfect technology spillovers, which refers to friction in learning others' technology in the process of external innovation. In contrast to existing models, this friction allows incumbent firms to defend themselves from competitors by building technological barriers through internal innovation. Using firm-level data from the U.S. Census Bureau integrated with firm-level patent data, we find regression results consistent with the model predictions. Our counterfactual analysis shows that rising competition leads incumbent firms to undertake (i) more (less) internal innovation for the products they have a (no) technological advantage in, and (ii) less external innovation. This compositional change in firm innovation affects overall innovation in the aggregate economy in different directions depending on the costs of external innovation. Specifically, the shift in innovation composition in response to rising competition decreases overall innovation in the U.S. while increasing that in an economy with high external innovation costs. These findings highlight that the change in innovation composition resulting from firms' strategic choices is an important margin to understand the heterogeneous effect of increasing competition on overall innovation across different countries.