Competition and Innovation : The Inverted-U Relationship Revisited

I re-examine the inverted-U relationship between competition and innovation (originally modeled and tested by Aghion et al. (2005) by using data from publicly traded manufacturing firms in the US. I control for the possible endogeneity of competition by using a trade-weighted average of industry exchange rates as the instrument. I find a mildly negative relationship between competition (as measured by the inverse of markups) and innovation (as measured by citation-weighted patents). The relationship is robust to many alternative assumptions and specifications. To reconcile the mildly negative relationship in the US data with the inverted-U relationship that Aghion et al. (2005) find in the UK data, I modify their theoretical model and show that the modified model can explain both negative and inverted-U relationships. The key theoretical assumption is that the UK manufacturing industries are technologically more neck-and-neck than their counterparts in the US. I find support for this assumption in the data