Innovation and market structure: exploring the feedback effect, the role of policy regime and types of innovation

Abstract

The relationship between innovation and market structure is complex. Competitive forces in an industry reduce future rents associated with innovation and hence discourage firms from investing in such activities (Schumpeter 1942). On the contrary, product market competition increases firms’ efficiency through managerial-effectiveness which drives innovation (Arrow 1962). Aghion et al. (2005) advanced the debate by introducing the possibility of an inverted U-shaped relationship between innovation and competition. Such a nonlinear relationship occurs during a low level of competition in an industry where firms intend to escape the competition by innovating new products. Later, the pace of competition reduces and few winners emerge, thus catalyzing the Schumpeterian effect. It implies that those firms which are technological leaders dominating the industry are ultimately responsible for a negative relationship between competition and innovation.On the other hand, scholars associated with the Chicago School of Thought on innovation and market structure which mainly emerged in 1970, argue that market dominance arises from superior efficiency which is a function of technological advancements (Shepherd 1990). Technological advancements are a source of economies of scale and efficiency which positively influence firms’ market power. Thus, innovation influences firms’ monopoly power and help these firms in sustaining market dominance. New products and processes provide the means for large and old firms to create high entry barriers. However, this positive impact prevails up to an optimal level only. Afterwards, monopoly shows a declining trend with further increase in innovation (Nemlioglu & Mallick 2017). Nemlioglu and Mallick (2017) show that theSchumpeterian theory of creative destruction plays a very important role for explaining this inverted-U shaped relationship.