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EBRD Transition Report 2014 – Box 3.3. Competition and innovation: a complex relationship

TRANSITION REPORT 2014 Innovation in Transition

Box 3.3. Competition and innovation: a complex relationship

Does stronger competition in product markets boost or hamper technological advances? The relationship between competition and innovation is complex, as multiple countervailing forces are at work.

On the one hand, concentrated markets with less competition may be more conducive to innovation. Large firms with substantial market power may be more willing to carry out innovation-oriented R&D activities because the scarcity of competitors will allow them to reap higher rents from newly introduced products if those innovations turn out to be successful. Market power may also help firms to finance R&D activities using retained earnings.

On the other hand, a lack of competition, while enabling firms to enjoy higher rents from new products, may also lead to complacency. In other words, firms may have more incentives to innovate in a competitive environment, in order to get ahead of their rivals and increase their market share.30

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The combination of these two effects may lead to a non-linear relationship between competition and innovation (such as an inverted U-shape).31 This shape may reflect the existence of two broad types of industry: “neck-and-neck” industries, in which companies operate with similar levels of technology, and “unlevelled” industries, in which a technological leader competes with a group of followers.

In neck-and-neck industries, competition encourages firms to innovate, because it allows them to move ahead of their competitors and increase their market share. In contrast, tougher competition discourages laggard firms in unlevelled industries from innovating, as the laggard’s reward for catching up with the technological leader declines. An inverted U-shape may emerge where neck-and-neck industries are more prevalent at low levels of competition, but then, as competition intensifies, more industries become unlevelled and further competition starts to put a break on innovation.

BEEPS V and MENA ES data broadly confirm the existence of an inverted U-shape in transition economies (see Chart 3.3.1). This chart plots innovative output in the SEE and CEB regions against the distribution of the number of competitors, showing that the average percentage of firms introducing a new or improved product or process initially increases with the number of competitors, before then declining in the third and fourth quartiles of the distribution. The chart also shows that the inverted U-shaped relationship between competition and innovation translates into a similar relationship between competition and firms’ growth.

Empirical evidence suggests that the positive impact that competition has on innovation is stronger for older firms. This is consistent with the view that older firms are inherently less likely to innovate unless they are spurred on by competition.32 Overall, the literature seems to conclude that some degree of market power appears necessary for stimulating innovation activity, coupled with competitive pressure (especially pressure from foreign competitors).

Competition policy

There is a broad consensus that well-designed and properly enforced competition policies are beneficial to innovation. Competition-enhancing policies can be broadly divided into two groups. First, product market deregulation aims to remove barriers to entry, trade and economic activity, as well as limiting the state’s direct interference in economic activity. Second, competition laws provide a legal framework for the prosecution of anti-competitive conduct, cartels and the abuse of dominant positions, as well as reducing the anti-competitive effect of mergers.

Product market deregulation has consistently been found to increase the adoption of state-of-the-art production techniques, as well as the introduction of new technologies. As a result, deregulation may ultimately translate into stronger total factor productivity growth.33

Conversely, restrictive product market regulations limit the productivity of the industries concerned. This is particularly true of industries that are a long way from the technological frontier. In these industries, restrictive regulations tend to halt the catching-up process.

Recent analysis also shows that anti-competitive product market regulations in upstream sectors curb productivity growth even in very competitive downstream sectors. In other words, a lack of competition in upstream sectors can generate barriers to entry that curb competition in downstream sectors as well, reducing pressures to improve efficiency in those sectors. For example, tight licensing requirements in retail or transport sectors can restrict access to distribution channels, while overly restrictive regulation in banking and financial sectors can reduce sources of financing, affecting all firms in the economy.34

When it comes to the enforcement of competition law, the existence of a complex relationship between competition and innovation has sometimes been interpreted as meaning that more lenient standards should be adopted when it comes to innovative industries. The complicated relationship between competition and innovation does call for a more comprehensive assessment of the impact that specific actions have on market participants’ ability to innovate and the incentives they have. However, it does not justify the blanket dismissal of all concerns about anti-competitive behaviour in industries that are deemed to be innovative.

A proper assessment of innovative industries requires well-designed competition laws and competent competition authorities. The enforcement of competition law can play an important role in supporting innovation by allowing actions that promote innovation (such as mergers) and prohibiting actions that hamper it. Recent evidence from OECD countries points in this direction, showing that sound competition policies lead to stronger total factor productivity growth (which may be seen as a proxy for innovation).35

Data for the transition region show the positive effect that competition-enhancing policies have on innovation. Chart 3.3.2 shows that there is a positive relationship between the quality of competition-enhancing policies (as measured by the EBRD’s competition indicator, which assesses the quality of competition law, the institutional environment and enforcement activities)36 and innovation. While the chart does no more than indicate a correlation between the two, this nevertheless points to a link between the quality of competition policy and the strength of innovation.

All in all, while the relationship between competition and innovation is a complex one, well-designed competition policies can help to provide the right business environment, allowing companies to fulfil their competitive potential and having a positive impact on innovation.

CHART 3.3.1

Source: BEEPS V, MENA ES and authors’ calculations.

CHART 3.3.2

Source: EBRD (2013), Cornell University et al. (2014) and authors’ calculations.