Wednesday, October 8, 2014

1:56 PM

Ronald Goettler

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Ron Goettler's new study looks at how
competing firms invest in innovation to
increase overall market share.
How does increased competition affect product innovation? A paper by senior associate dean Ronald Goettler, “Competition and Product Innovation in Dynamic Oligopoly,” tackles this important question, relevant to corporate strategy.

“We analyze the relationship between competition and innovation using a model with important features missing from most previous studies,” says Goettler, who is the James N. Doyle, Sr. Professor of Entrepreneurship.

In particular, most studies analyze the effect on innovation of hypothetically adding or removing firms. But measuring competition using the number of firms is inappropriate, Goettler says, because it’s influenced by the same factors that drive incentives to innovate. He focuses on three such factors: entry costs, the ability of firms to copy each other’s advances, and the degree of product substitutability in an industry.

Consider the last of these. The more similar products are, the more substitutable they are, and thus the competition is greater even if few firms are competing. For example, just two companies, Intel and AMD, control 95 percent of the PC microprocessor market. Despite the low number of competitors, competition is fierce: both companies invest heavily to produce faster and more power-efficient CPUs to satisfy consumers.

In contrast, if only two firms were to compete in the fashion industry, each would have little incentive to innovate, because most fashion products are poor substitutes for one another. Instead, competition in this industry results from the large number of firms that enter in response to the low product substitutability.

For many years, economists have debated the effect of competition on innovation. Firms need market power to generate the increased profits that make investments in innovation worthwhile. Some researchers, starting with Joseph Schumpeter in the 1940s, have argued that increased competition reduces market power and therefore reduces innovation. Others have argued that firms with market power already have high profits and therefore low incentives to innovate, and that reducing market power via more competition spurs innovation.

Goettler and co-author Brett Gordon, of Northwestern University, find that accounting for the effect of competition on the number of firms is important and gives rise to an inverted-U relationship between competition and industry innovation, measured as the rate at which the industry’s frontier product improves. “When product substitutability is low, increasing substitutability leads to more innovation,” he says, “as firms innovate to protect their own market share and to steal market share from the large pool of competitors.” 

“But as substitutability gets very high, the lead firm captures most of the profits and laggard firms exit,” Goettler says. “The lead firm invests heavily to protect its lead when laggards are close, but because laggards have few profits to invest in R&D, eventually the leader pulls away and reduces its investments once it’s securely ahead.”

The result, he says, is that further increases in substitutability lower innovation, yielding the downward portion of the inverted U.

By Sally Parker

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