Competition Laws and Corporate Innovation

Does competition increase or decrease innovation? Many researchers stress that more intense competition discourages innovation by shrinking profits. Why spend money on innovation if other firms quickly develop products that compete away the profits. Other research, however, emphasizes that more intense competition encourages innovation by making markets more contestable: to get any profits in a highly contested market, currently dominant and other firms need to innovate to stay head, or get ahead, even if it is only for a short time period. Since quantifying the impact of competition on innovation has implications for antitrust policies, an enormous empirical literature assesses the competition-innovation nexus. 

Two key empirical challenges, however, have plagued past research on this central question. First, common proxies for competition, such as firm size and industry concentration, might not accurately measure the contestability of markets. Second, many studies use patents to measure innovation, but firms may choose to patent or not patent an innovation based on the expected benefits of the legal protection offered by the patent relative to the expected costs of disseminating detailed information about the innovation via the patent to competitors. Thus, firms might increase or decrease patents based on changes in these strategic cost-benefit calculations, not because of changes in actual innovation. 

In a recent paper, ‘Competition Laws and Corporate Innovation,’ we make three contributions that help address these challenges and offer new results concerning the impact of competition on innovation. First, we create two unique datasets on patenting. The firm-level dataset has information on each firm’s patents and financial accounts, across 66 countries, from 1991 through 2015. Using this new dataset with over 1.2 million firm-year observations, we construct measures of the number, impact, and explorative nature of corporate patents. The second dataset includes country-industry information on patenting in 186 countries from 1888 through 2015. With our unique data, we provide the first examination of the relation between competition and patenting in a large, international panel of private and public firms.

Second, we combine these data with insights from corporate finance and develop a strategy for (a) reducing concerns about using patents as a proxy for innovation and (b) drawing causal inferences. In particular, corporate finance predicts that the impact of competition on a firm’s investment in innovation depends on the extent to which (i) the firm is constrained in raising funds to make those investments and (ii) the firm has influential owners with large proportions of their personal wealth exposed to the firm, making them reluctant to having their firms invest more in risky projects such as innovation. Evidence confirming these predictions would not only be consistent with the view that competition increases incentives for firms to invest in innovation. It would also reduce concerns that competition increases patenting primarily by adjusting the strategic cost-benefit calculations of patenting a given innovation, rather than by changing innovation per se. The reason is that corporate finance offers clear conceptual reasons for expecting that competition will increase investment in risky, innovative endeavors more in less financially-constrained firms and firms with less financially-exposed owners, but there are less clear arguments for why competition will differentially alter the strategic decision to patent or not patent a given innovation based on financing constraints and ownership structure. Furthermore, since corporate finance research highlights particular mechanisms through which competition shapes innovation, empirically confirming these mechanisms enhances our ability to identify the impact of competition laws on innovation. 

Third, we are the first to use a new, comprehensive dataset on competition laws to examine the relation between competition laws and patenting. That is, rather than analyzing measures of firm size or industry concentration, we examine the statutory laws that regulate competition among firms. We use the Bradford and Chilton (2018) data on laws that regulate mergers and acquisitions, the use of anticompetitive agreements, the abuse of dominant positions, and who has the authority and tools to address and remedy violations of those statutes.[1] 

We discover:

1. When countries intensify the degree to which their laws encourage product market competition, innovation increases, as measured by our patent-based measures of innovation. 
2. The innovation-boosting effects of laws that limit anti-competitive behaviors are smaller among firms that are more financially constrained, ie, among  firms that face greater barriers to raising the funds necessary for making additional investments in innovation, such as smaller firms, younger firms, and privately-held (as distinct from publicly-listed) firms.
3. The innovation-boosting effects of competition are smaller among firms that have owners with more of their personal wealth invested in the firm,  such as family-controlled firms—firms where a family owns more than 50% of the voting rights, since those families will tend to have a large proportion of their wealth concentrated in the firm and be correspondingly more averse to their firms increasing investments in the risky process of innovation.

Ross Levine is the Willis H. Booth Chair in Banking and Finance at Haas School of Business, University of California, Berkeley. 

Chen Lin joined is the Chair of Finance at the HKU Business School, University of Hong Kong (HKU).

Lai Wei is Associate Professor at the Faculty of Business, Lingnan University.

Wensi Xie is Assistant Professor of Finance at the CUHK Business School, Chinese University of Hong Kong.

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[1] Bradford, A., Chilton, A.S., 2018. Competition law around the world from 1889 to 2010: The competition law index. Journal of Competition Law & Economics 14, 393-432.