Innovation, Competition and Incentives for R&D

Exploring the links between the type of innovation and the type of competition is essential to understand the mutual impacts of competition policy and innovation policy. This is of particular importance for countries which rely on innovation as a competitive advantage such as Germany and Switzerland, which are the focus countries of the empirical analysis. The paper investigates three research questions: Is there a relationship between past innovation output and the type of competition? Do product and process innovation exert different impacts on the type of competition in the sales markets? Does the type of competition affect incentives for future investment in innovative activities? Following the theoretical findings of Vives (2008) who states that the degree of product substitutability and the extent of fixed costs – as two important characteristics of competition - are both positively correlated with process innovation effort and negatively correlated with product innovation effort, we analyse the links between past and future innovation efforts and these two types of competition. The empirical analyses rest on firm-level data from Germany and Switzerland. We use firms' own assessments on the degree to which their products are substitutable by competitors' products and the speed of product obsolescence (which should be negatively correlated to the extent of fixed costs) as measures for competition. We find for both countries that innovation output in t-1 as measured by the sales share of innovative products is positively related to the degree of product obsolescence in t, and negatively to the degree of substitutability in t in both countries. This result indicates that it is product innovation that drives technology competition which points to the fact that a lack of product innovations urges firms into substitution competition. We find different results by country in terms of process innovation: Cost reductions by German firms tend to increase product obsolescence and reduce substitutability, indicating that cost saving process innovation is a strategy to improve price competitiveness both in markets with rapid technological aging or with a high degree of product substitution. For Switzerland, we find a negative effect of process innovation on product obsolescence, i.e. cost savings are primarily used to lower product prices in mature markets with low technological dynamics. For the effect of the type of competition on future innovation effort, we find different results for the two competition variables. While great product obsolescence provided positive incentives for future R&D investments (which are primarily oriented to product innovations), great substitutability provided negative incentives for R&D investment. Thus, we found a ‘vicious circle’ for product substitutability indicating that firms in such markets are under increasing cost pressure and can to a much lesser extent afford innovative activities that lead to product innovations. In contrast, a high degree of product obsolescence leads to greater R&D investments in the future period. Our results indicate that innovation and competition tend to reinforce each other (positively or negatively), and it is difficult for firms to change a chosen path.

Wörter, Martin, Christian Rammer and Spyros Arvanitis (2010), Innovation, Competition and Incentives for R&D, ZEW Discussion Paper No. 10-039, Mannheim.