Question

How can increasing the amount of competition (by encouraging more firms to enter an industry) aid innovation? How can increasing competition hinder innovation? Explain via a diagram.

Answer 1

The current economic and industrial climate calls for high-levels of innovation. This innovation is not limited to microeconomic levels but has also started to matter on the macroeconomic level as countries along with its respective firms attempt to find strong ground in the international market.

There are numerous programs launched by a hand-full of countries that promote competition to encourage innovation. An example is the $19 million grant by the British government to encourage innovation in the countries start-ups and established firms. On the other hand, the U.S.A has an upward of 7 initiatives that aim to propagate entrepreneurial competition to achieve higher levels of innovation. To name a few of these initiatives: The i6 Challenge, and the Social Innovation Fund.

But the question directs us to the matter of how competition could aid in innovation, and if a competitive environment has drawbacks on cultivating innovation.

Innovation Competition

(Diagram 1)

Competition does breed innovation as in a competitive market firms are driven to adopt increasingly efficient production approaches to stay ahead of the ever-increasing competition in the industry. Firms do this by coming up with innovative products with new features and at lower prices to set their products apart from the competitors. The initial competition does appear to increase the incremental profits from innovation, which is likely to be done in an effort to exit the competitive environment and gain, first technological and then market leadership, but such positive correlation appears most in firms who are in a "neck and neck" market. In highly competitive industries the innovation usually takes place to reduce production costs which leads to the possibility of higher profits (as shown in the diagram below). As production becomes more efficient, the average cost drops along with marginal cost, increasing the consumer surplus. Lower costs lead to higher profits.

Pricecp 4 witial consumen enephe аdеd социд Оли Америл реа demand curve © фо Quantity (g) tou

(Diagram 2)

However, competition also hinders the level of innovation that can be generated. Firstly, in a market that is highly competitive the amount of profits generated are so low that it becomes unfeasible for companies to invest these profits into R&D. Secondly, in competitive markets lead to a good exchange of information, therefore any innovation made can be copied by others easily, or in other words, the higher the product market competition the higher the rate of imitation in the market. Due to this firms are hesitant to invest in innovation, and fish for incentives such as patents and barriers to entry, which dampen the level of competition.

Therefore, it can be said that the level of competition in the market is the most essential factor with regards to innovation. The theorized relationship between innovation and competition is an inverted U-shaped curve. With innovation on the y-axis and the degree of competition on the x-axis (diagram 1). We can conclude that positive correlation between innovation and competition can be attributed to the "escape-competition" effect, and as competition increases beyond the tipping point the incentive to innovate drops due to reasons such as increase in imitation rate, and low profits.