Information Acquisition and Innovation under Competitive Pressure

• Author: Andrei Barbos
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jems.12096
• Date: 01 June 2015

Information Acquisition and Innovation under

Competitive Pressure

ANDREI BARBOS

Department of Economics

University of South Florida

4202 East Fowler Avenue, CMC 206, Tampa, FL 33620-5500

andreibarbos@gmail.com

This paper studies information acquisition under competitive pressure and proposes a model to

examine the relationship between product market competition and the level of innovative activity

in an industry. Our paper offers theoretical support for recent empirical results that point to

an inverted-U shape relationship between competition and innovation. The model presents an

optimal timing decision problem where a firm endowed with an idea trades the benefits of waiting

for additional information on whether this idea can be converted into a successful project against

the cost of delaying innovation: a given firm’s profit following innovation is decreasing in the

number of firms that invested at earlier dates. By recognizing that a firm can intensify its

innovative activity on two dimensions, a risk dimension and a quantitative dimension, we show

that firms solve this trade-off precisely so as to generate the inverted-U shape relationship. The

dynamic setup of our model offers insights not just in the cross-section on the relationship between

competition and innovation, but also intertemporally on the optimal timing of innovation at firm

level.

1. Introduction

This paper studies information acquisition under competitive pressure and employs

the resulting model to investigate the relationship between the degree of competition

in an industry and the intensity of innovative activity. The clear policy implications of

the nature of this relationship generated a large body of literature that investigated it.

Beginning with the seminal work of Schumpeter (1943), the objective of these studies has

been to determine whether there is an optimal market structure that resultsin the highest

rate of technological advance. In particular, the literature tried to reconcile the intuitive

appeal of Schumpeter’s assertion that only large firms possessing a significant amount of

monopoly power have the resources and incentive to engage in risky innovative activity,

with a substantial amount of empirical literature that did not confirm it. More recent

empirical papers, such as Aghion et al. (2005) suggest an inverted-U shape relationship

between product market competition and innovation.1According to these studies, for

low levels of competition, an increase in competition induces more innovation, whereas

for higher values of competition, as competition increases, firms become less innovative.

Our paper adopts a microeconomic approach and constructs a model that studies

the innovation process at firm level by following a new project through its stages of

I have benefited from helpful feedback from Alessandro Pavan and Marciano Siniscalchi. I also thank com-

ments and suggestions from the editor,two referees, Andrew Daughety, Eddie Dekel, Silvana Krasteva, Sorin

Maruster, Asher Wolinsky,and from audiences at USF, FSU, IIOC 2010, and ESWC 2010. All errors are mine.

1. Scherer (1967) is the first empirical paper to uncover this shape. See also Scott (1984) and Caves and

Barton (1990).

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 2, Summer 2015, 325–347

326 Journal of Economics & Management Strategy

development. The firms in our dynamic model become sequentially aware of an inven-

tion and decide on whether and when to undertake a costly investment in innovation.

In making this decision, firms face a trade-off between seeking a first-mover advantage

and waiting to acquire more information. Our study brings three main contributions to

the literature. First, we identify the trade-off between information acquisition and com-

petitive pressure as sufficient to generate the empirically observed inverted-U shape

relationship. Second, we propose a new dimension, the risk dimension, on which a firm

can intensify its innovative activity. Due to the strong intuitive nature of Schumpeter’s

assertion, the vast majority of theoretical models investigating the relationship between

competition and innovation obtained a negative relationship. By disentangling the level

of innovative activity along two dimensions, the quantitative and risk dimensions, we

succeed in offering an explanation for the positive segment of the relationship.2Finally,

the dynamic setup of our model offers insights not just in the cross-section on the rela-

tionship between competition and innovation, but also intertemporally on the optimal

timing of innovation at firm level. Thus, although our model aims at explaining an

empirical fact of public policy relevance, from a managerial viewpoint, its results elicit

how forward-looking profit-maximizing firms should adjust their innovative activity in

response to increased competitive pressure.

The model has a set of firms who, through their applied research activity, discover

an invention or an idea that could generate future revenues for its investors, provided

that it is a success from both a technological and a business standpoint. Once a firm is

aware of the idea, it has the option to invest in the innovation of that project at any time.

Innovation means the development of a marketable product; it is the stage in the R&D

process where the first substantial financial commitment to the project is made and large

R&D labs spend most of their resources on innovation. For instance, of the $208.3 billion

spent on industrial R&D in the United States in 2004, $155.1 billion (or 74.5% ) were

spent for development.3

When firms first learn of an idea, their knowledge about its feasibility is scarce, so

investment is risky.As time passes, a firm in our model acquires new information and is

able to better assess its chances of success. This additional information may lead a firm

to decide not to invest in the project. This makes waiting beneficial as it can potentially

aid avoiding the financial losses associated with the development of an unsuccessful

product. In real world, the information employed to screen out the less promising

project can take a variety of forms. First, this information can be technological, in the

form of test results, or knowledge about the technological trend for complementary

products. For instance, the potential developers of a hybrid or electric car may have had

an incentive to wait to see if more efficient batteries could be produced. Second, this new

information could also be commercial in the form of marketing research. For instance,

the same car manufacturer may have waited to investigate whether and how many

consumers are willing to compromise and accept the limitations of these new products.

Third, the information may come in the form of knowledge about the overall economic

2. Also, our model can be seen as a study of product innovation where new products are introduced in

the market. This differs from most of the theoretical literature on innovation, including Aghion et al. (2005),

which focuses on process innovations where existing products are produced at a lower average cost.

3. Source: National Science Foundation, Division of Science Resources Statistics. 2008. Research and Devel-

opment in Industry: 2004.