Elsevier

Research Policy

Volume 38, Issue 5, June 2009, Pages 861-870
Research Policy

Competition favors the prepared firm: Firms’ R&D responses to competitive market pressure

https://doi.org/10.1016/j.respol.2009.01.005Get rights and content

Abstract

This paper aims to contribute to the literature on the long-debated relationship between market competition and firm research and development (R&D) by investigating the effect of competitive market pressure on firms’ incentives to invest in R&D. The paper shows that a firm's R&D response to competitive market pressure depends primarily on its level of technological competence or R&D productivity: firms with high levels of technological competence tend to respond aggressively (i.e., exhibit a higher level of R&D efforts) to intensifying competitive market pressure, while firms with low levels of technological competence tend to respond submissively (i.e., exhibit a lower level of R&D efforts). The differential effect of competitive market pressure on firm R&D, conditioned primarily by the level of firms’ technological competence, is empirically supported by unique firm-level data from the World Bank. Furthermore, the role of firm-specific technological competence in conditioning the R&D–competition relationship is more evident and statistically more significant for firms facing consumers whose utility is relatively more elastic to product quality than to price.

Introduction

Market competition (or rivalry), and market structure in general, has been a central theme in the areas of strategic management and industrial organization, since it affects various aspects of firm behavior and market performance. In particular, the relationship between market structure and research and development (R&D) has been drawing a considerable amount of attention from both researchers and policy-makers. There is now a large body of literature on the relationship between market concentration and industry R&D (e.g., Lee, 2005, Aghion et al., 2005, Gottschalk and Janz, 2001, Van Cayseele, 1998, Symeonidis, 1996, Scherer and Ross, 1990, Geroski, 1990, Cohen and Levin, 1989, Angelmar, 1985, Kamien and Schwartz, 1982).

Unlike the abundance of studies on the effect of market competition, measured at the industry level by seller concentration ratios, on industry R&D, there are only a few studies that have examined R&D responses to competitive market pressure at the firm level. This is largely due to the difficulty of capturing the notion of competitive market pressure empirically. Furthermore, many studies (e.g., Cohen and Levin, 1989, Boone, 2000, Pereira, 2001, Tang, 2006) have pointed out that the predictions and findings of the existing studies on the effect of various forms of market competition on firm R&D behavior are diverse and often conflicting, mostly because of differences in theoretical models, ad hoc empirical specifications or data limitations.1 For example, Lee and Wilde (1980), Bertschek (1995), Blundell et al. (1995), and Nickell (1996) support the idea that competition favors innovation,2 while Loury (1979), using a patent-race model, and Martin (1993), using a Cournot principal-agent model, have shown that market competition has a negative effect on firms’ incentives to increase their R&D efforts.3 Meanwhile, after analyzing the R&D reactions of 308 U.S. corporations to high-tech import penetration in the U.S. markets during the years 1971–1987, Scherer (1992) and Scherer and Huh (1992) found that reactions varied widely from industry to industry, without any homogeneous behavioral pattern.

Several recent studies based on (production) cost asymmetry have predicted differential effects of competitive market pressure on firms’ incentives to invest in lowering production costs. Boone (2000) and Aghion and Schankerman, 1999, Aghion and Schankerman, 2000, for example, predict that the effect of market competition, variously defined, on a firm's incentive to invest in R&D depends on its level of cost efficiency relative to the efficiency levels of its rivals.4 Even though the predictions of these studies are quite intuitive, they are somewhat limited, particularly in the sense that they are based on horizontal differentiation (i.e., cost asymmetry in either production or transportation) and that none of these studies provide empirical evidence for their predictions, probably because of the difficulty of measuring firm heterogeneity in cost efficiency and of empirically capturing the level of competitive market pressure perceived by individual firms.5

The purpose of this paper is to contribute to the existing literature by investigating the effect of competitive market pressure on firm R&D behavior. First, based on a demand-pull, technological-competence-push model of firm R&D, this study analyzes the effect of increased market competition, as perceived by a firm, on its profit-maximizing level of R&D expenditure and R&D intensity (i.e., R&D-to-sales ratio). The approach taken in this analysis is different from those in previous studies in two respects: it employs a discrete-choice market-share model to identify an appropriate term that closely represents competitive market pressure faced by each individual firm, and, unlike previous studies (e.g., Boone, 2000, Boone, 2001, Aghion and Schankerman, 1999, Aghion and Schankerman, 2000), it explicitly considers firm heterogeneity in technological competence (or R&D productivity).

Second, this study uses unique firm-level data constructed by the World Bank to empirically test the predictions drawn from the analysis. The data set is unique, particularly in the sense that it provides a self-evaluated measure of the degree of competitive market pressure perceived by each individual firm in both the domestic and global markets. As such, it is more sophisticated than the survey-based dummy variables employed in existing studies (e.g., Stewart, 1990, Nickell, 1996) and the frequently used measures of overall market concentration (e.g., seller–concentration ratios and the Herfindahl-Hirschman Index).6 Furthermore, as described by Tang (2006), the self-evaluated perception-based measure of market competition has several merits and is particularly suitable for analyzing individual firms’ R&D responses to competitive market pressure.

Our analysis predicts that the effect of competitive market pressure on a firm's incentive to invest in R&D depends primarily on its level of technological competence: firms with high levels of technological competence are more likely to respond aggressively (i.e., increase R&D) to intensifying competitive market pressure, whereas firms with low levels of technological competence tend to react submissively (i.e., reduce R&D).7 Empirical analysis of the World Bank data supports the differential effect of competitive market pressure, conditioned by firm-specific technological competence, on firm R&D. This finding is consistent with the selection and adaptation effects of market competition (e.g., Boone, 2000), and implies that competitive market pressure separates more technologically competent firms from those that are less technologically competent and drives them to be more R&D-intensive.

The paper is organized as follows. Section 2 derives a model of firm R&D and a measure of competitive market pressure perceived by individual firms. Section 3 analyzes the effect of competitive market pressure on firm R&D expenditure and R&D intensity. Section 4 empirically tests the predictions of the analysis, and Section 5 concludes the study.

Section snippets

A model of firm R&D and competitive market pressure

This section develops a model of firm R&D and a measure of market competition that reflects the degree of competitive market pressure faced (or perceived) by each individual firm. Consider a monopolistically competitive industry with N firms, each producing a vertically differentiated product. The setup of the model is as follows.

First, using a discrete-choice model of demand (e.g., Anderson et al., 1992), firm i's market share (mi) is represented as the probability that a representative

Firm R&D responses to competitive market pressure

One of the most important questions in the study of firm R&D behavior is whether competitive market pressure increases or decreases individual firms’ incentives to invest in R&D. The answer to this question has important implications for business strategies and competition policies in areas such as antitrust, economic deregulation and trade liberalization policies. However, as was briefly mentioned in Section 1, existing studies provide diverse and often conflicting results, predicting that

Empirical implications, data and variables

Using unique firm-level data from the World Bank on R&D intensity, firm-specific technological competence and the degree of competitive market pressure evaluated by each individual firm, this section tests empirically the predictions drawn from the analysis of the relationship between firm R&D and competitive market pressure and, in particular, the role of technological competence in conditioning the R&D–competition relationship. The key empirical implications to be tested in this section are

Concluding remarks

This paper has examined the effect of competitive market pressure on firms’ incentives to invest in R&D using a simple model of firm R&D and a multi-country firm-level data set constructed by the World Bank. In doing so, the study explicitly considers firm heterogeneity in technological competence and employs a unique measure of competitive market pressure perceived and self-evaluated by individual firms, which seems more appropriate than the conventional, indirect, measures of market

Acknowledgements

The author thanks his dissertation advisor at Harvard, Frederic M. Scherer, and other seminar participants at Harvard and KAIST Business School for their invaluable comments and advice on the early version of this paper. The author also thanks Editor Stefan Kuhlman and two anonymous referees for their encouragement and invaluable comments.

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    This paper was completed during the author's sabbatical leave at Harvard's John F. Kennedy School of Government.

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