Competition, patent protection, and innovation with heterogeneous firms in an endogenous market structure

• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/jpet.12415
• Date: 01 June 2020
• Author: Keishun Suzuki

J Public Econ Theory. 2020;22:729–750. wileyonlinelibrary.com/journal/jpet © 2019 Wiley Periodicals, Inc.

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729

Received: 15 May 2019

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Accepted: 4 November 2019

DOI: 10.1111/jpet.12415

ORIGINAL ARTICLE

Competition, patent protection, and

innovation with heterogeneous firms in an

endogenous market structure

Keishun Suzuki

Graduate School of Social Sciences, Chiba

University, Inage‐ku, Chiba, Japan

Correspondence

Keishun Suzuki, Graduate School of

Social Sciences, Chiba University,

1‐33, Yayoi‐cho, Inage‐ku, Chiba

263-0022, Japan.

Email: ksuzuki@chiba-u.jp

Funding information

Japan Society for the Promotion of

Science, Grant/Award Number:

16K17109

Abstract

This paper revisits the relationship between competition

and innovation by incorporating the heterogeneity of

R&D efficiency across firms and an endogenous market

structure in a dynamic general equilibrium model.

Using an analytically tractable model, we show that

competition and innovation can have either an inverted‐

U or a negative relationship, as reported by several

empirical studies. Furthermore, we show that the effect

of strengthening patent protection on innovation de-

pends on the competition level. In particular, we find a

complementary relationship between competition policy

and the strengthening of patent protection.

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INTRODUCTION

Does stronger product market competition (PMC) stimulate innovation? Despite the attempts of

many researchers to answer this question over the years, the findings continue to be

theoretically and empirically controversial.

1

According to an idea forwarded by Schumpeter

(1950), monopolistic profit is the most powerful engine driving technological progress and

stronger PMC discourages firms from innovation because postinnovation profits tend to shrink

(also known as the “Schumpeterian effect”). In fact, several empirical studies (e.g., Hashmi,

2013; Mulkay, 2019) show that the relationship between PMC and innovation is negative.On

the contrary, Aghion, Bloom, Blundell, Griffith, and Howitt (2005), the most influential paper

in the literature, show an inverted‐Urelationship between PMC and innovation. Furthermore,

the authors propose a positive effect of PMC on innovation by constructing a duopolistic

1

For a comprehensive survey of empirical studies, see Cohen (2010).

step‐by‐step innovation model to explain the nonmonotonic relationship between PMC and

innovation. They show that two technologically equal firms increase their R&D effort when

stronger PMC decreases their current profits because they have an incentive to quickly achieve

a monopolistic position before the rival (also known as the “escape competition effect”).

This paper provides a tractable dynamic general equilibrium model that makes several

contributions to the extant literature. First, our model shows that the relationship between PMC

and innovation can be either inverted‐U or negative. This result reconciles the above‐mentioned

mixed evidence. Second, we can show the inverted‐U relationship between PMC and

innovation despite considering free‐entry in our model. As Etro (2007) points out, the

nonmonotonicity between PMC and innovation in Aghion et al. (2005) disappears under an

“endogenous market structure (EMS).”More specifically, the escape competition effect in their

model disappears if the number of firms is endogenously determined by the free‐entry

condition.

2

Therefore, our model also reconciles the result of Aghion et al. (2005) with the EMS

proposed by Etro (2007).

Our model is related to other EMS models in the literature.

3

For example, Bento (2014)

incorporates the uncertainty of quality‐improvement size in a Schumpeterian growth model,

wherein the incumbent’s markup is endogenously determined. In his model, a fortunate

potential firm that draws the best quality among all of the firms becomes a monopolist as a

result of Bertrand competition. Lowering the fixed cost of R&D increases the number of firms

that draw the lottery, but also decreases the probability of one firm winning (this discourages

each firm’s research via the Schumpeterian effect) and increases the winner’s quality level and

innovation value (he calls this the “Hayekian effect”). Bento (2014) further shows that these

opposite effects generate an inverted‐U relationship between PMC and research per firm. On

the contrary, his model fails to show the negative relationship found by some empirical studies.

Our model has several notable features in comparison to those in the existing studies. First,

we explicitly consider PMC among existing firms by incorporating Cournot competition within

each industry into the quality‐ladder model in Grossman and Helpman (1991, Chapter 4). This

is in contrast to the original model and those in other subsequent studies, including Bento

(2014), which assume Bertrand competition. In their models, the leader charges a limit‐price to

prevent potential firms from entering the market. Therefore, there is no PMC among existing

firms in their models, although the leader faces competitive pressure from the potential firms.

In reality, it is hard to find such a monopolistic industry. However, we can easily observe PMC

among several existing firms in oligopoly markets. Moreover, as Bertrand competition with

homogeneous goods is a perfectly competitive situation already, it is difficult to treat

procompetition policies in such a model. Hence, we believe that the Cournot competition is

more appropriate than Bertrand competition in building a model that is realistic and has room

for the investigation of PMC policies.

Second, existing firms perform R&D activities in our model. This is in contrast to Grossman

and Helpman (1991, Chapter 4) and other subsequent studies because they assume that only

potential firms engage in R&D activities. In their model, no existing firm has an incentive to

2

Morita, Sawada, and Yamamoto (2019) also construct an EMS model in which labor market friction and lump‐sum subsidy are incorporated. The authors show

that the number of firms depends on the subsidy rates.

3

Denicolò and Zanchettin (2010) also propose a quality‐ladder growth model in which the total number of asymmetric incumbents is endogenously determined.

In their model, several efficient incumbents can remain in the market even if further innovation occurs because patent length is infinite and firms do not engage

in Bertrand competition. The authors use a parameter of conjectural variations, which has been criticized by many theorists, as a measure of competition level.

The authors show that strong PMC excludes inefficient incumbents from the market and increases the market share of an efficient incumbent. Hence, strong

PMC may stimulate the incentive to innovate through this market selection process.

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SUZUKI