Competition and Innovation: An Inverted-U Relationship*

This paper investigates the relationship between product market competition and innovation.We find strong evidence of an inverted-U relationship using panel data.We develop a model where competition discourages laggard firms from innovating but encourages neck-and-neck firms to innovate.Together with the effect of competition on the equilibrium industry structure, these generate an inverted-U.Two additional predictions of the model-that the average technological distance between leaders and followers increases with competition, and that the inverted-U is steeper when industries are more neck-and-neck-are both supported by the data.