Many previous studies suggest that increased competition reduces the amount of effort that goes into innovation because it encourages companies to target their resources to other areas where they are more likely to see results in the short term. In the paper "Innovation and Competitive Pressure", IESE Professor Xavier Vives demonstrates that precisely the opposite is true: In most cases, competitive pressure is a stimulus to innovation.
Vives's study is based on the two most basic models in oligopoly theory: the Bertrand model, in which companies compete on price with differentiated products, and the Cournot case, in which companies compete on quantity of a single homogeneous good. Vives establishes a set of rules: 1) competition is symmetric; 2) investing in innovation always yields benefits, as opposed to a hypothetical patent war in which the winner takes all; and 3) R&D investment does not entail a strategic commitment.
Both the Bertrand and the Cournot cases are empirically relevant, although Vives considers Bertrand competition with differentiated products and free market entry particularly interesting. In the Bertrand scenario, it would be possible for a company to enter a new market as a competitor. All it would have to do is to produce a new variety, pay a fixed entry cost, and then decide how much to spend on innovation in order to reduce variable costs (of production). Professor Vives complements his study by verifying the robustness of his findings in scenarios with different rules to those established for his main analysis.
The Cournot and Bertrand models are subjected to two basic scenarios: free entry (companies gain entry by paying a fixed cost) and restricted entry. In the free entry scenario, the indicators of competitive pressure are: product substitutability, market size, or ease (cheapness) of entry. In the restricted entry scenario, competition again is measured by product substitutability or number of competitors.
In markets with restricted entry, an increase in the number of competitors tends to translate into a decrease in R&D effort. In the Bertrand model, the result is consistent in almost all the types of market model tested. In the Cournot model, by contrast, the trend is maintained in the most paradigmatic case in which goods are strategic substitutes. Overall, Vives points out that there may be cases where increased competition translates into greater relative intensity of innovation effort. In other words, the ratio of R&D expenditure to sales may increase, without the total market expenditure being greater in absolute terms.
If instead of considering a larger number of companies we look at what happens if products are more substitutable, we find that under this assumption R&D effort increases, provided the market in which the products are sold does not get any smaller. This finding is consistent with the bulk of the specifications of the model that Professor Vives tests.
In free entry markets, an increase in market size translates into an increase in production and innovation effort in each company. However, it is impossible to determine how the number of companies is affected: It may increase or decrease. Vives explains why the number of companies willing to operate in a market may decrease as the market gets bigger: An increase in market size may lead to an increase in R&D expenditure large enough to dissuade many companies that might otherwise be interested in entering the market. This finding holds for both the Bertrand and the Cournot model.
At the same time, Vives emphasizes that if the fixed cost that companies pay to enter the market decreases, the number of competitors naturally increases. This translates into lower production and innovation effort by each individual company. Nevertheless, total market R&D investment (adding up all the companies) will usually be greater.
Lastly, greater product substitutability results in increased individual company investment and production, provided the market itself does not shrink. The number of companies may decrease (and will do if the market contracts), as greater competitive pressure leaves less room for new entrants.
While it is true that different findings may be obtained under certain circumstances, Vives concludes that competitive pressure does in fact stimulate innovation. His study shows that the relationship between indicators of competitive pressure and innovation does not depend on the type of mathematical specification used, and that it is found in both the Bertrand and Cournot models. Vives thus reconciles theory and practice while reviewing the factors governing the innovation phenomenon: market size, product substitutability, and fixed entry costs... not to forget, of course, the technology factor.