Competitive Environment and Innovation Intensity

Global Finance Journal 41 (2019) 44–59
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Global Finance Journal

journal homepage: www.elsevier.com/locate/gfj
Competitive environment and innovation intensity

T
Marcia Millon Cornetta, Otgontsetseg Erhemjamtsa, Hassan Tehranianb,
⁎
a
Department of Finance, Bentley University, Waltham, MA 02452, USA
b
Carroll School of Management, Boston College, Chestnut Hill, MA 02467, USA
ARTICLE INFO ABSTRACT
JEL classifications: We find a U-shaped relation between industry concentration and innovation. The relation is
D41 driven by neck-and-neck industries where firms operate with similar productivity. When industry
D42 concentration is low, innovation intensity decreases as concentration increases. However, when
D43 industry concentration is high, increased concentration causes industry firms to increase in-
L10
novation intensity to escape competition. The U-shaped relation is more pronounced in industries
L16
L21
where firms compete in strategic substitutes. Using tariff rate reductions as an exogenous shock
L22 to the competitive environment, firms in neck-and-neck industries and industries where firms
compete in strategic substitutes respond to foreign competitive threats by increasing innovation
Keywords:
intensity.
Industry concentration
Neck-and-neck industries
Strategic substitutes
R&D
Patents
1. Introduction
Since Schumpeter (1942), theoretical and empirical studies have explored the relation between product market competition and
innovation. Various theoretical arguments suggest that there is no simple monotone relation between competition and innovation.
Depending on the specific assumptions about the competitive environment (e.g., whether the setting is a duopoly or oligopoly, whether
firms in the industry are symmetric (leveled) or asymmetric (unleveled), whether laggards can leapfrog leaders or can only innovate
stepwise, and whether the nature of competition is Bertrand or Cournot), predictions of theoretical models vary (e.g., Aghion, Bloom,
Blundell, Griffith, & Howitt, 2005; Aghion & Howitt, 1992; Boone, 2001; Dixit & Stiglitz, 1977; Gilbert, Riis, & Riis, 2017; Romer, 1990;
Sacco & Schmutzler, 2011; Salop, 1977; Tishler & Milstein, 2009). Similarly, empirical studies provide mixed results. Scherer (1967)
and Aghion et al. (2005) discover an inverted-U relation between competition and innovation; Geroski (1990), Nickell (1996), Blundell,
Griffith, and Van Reenen (1999), and Schmitz (2005) find a positive linear relation; and Hashmi (2013) finds a mildly negative relation.
In this paper, we examine the link between competitive environment and innovation. We use various proxies for the competitive
environment including industry concentration, average productivity gap, and type of strategic interaction among industry firms.
Innovation is measured using R&D intensity and citation-weighted patents. Due to varying degrees of productivity among firms in an
industry (Boone, 2001), we divide sample industries into leveled (neck-and-neck) industries and unleveled (leader-laggard) industries
(Aghion et al., 2005). Neck-and-neck industries are those in which the average productivity gap is below the sample median. Leader-
laggard industries are those in which the average productivity gap is above the sample median. Due to varying degrees of strategic
⁎
Corresponding author.
E-mail addresses: mcornett@bentley.edu (M.M. Cornett), oerhemjamts@bentley.edu (O. Erhemjamts), hassan.tehranian@bc.edu (H. Tehranian).
https://doi.org/10.1016/j.gfj.2019.02.002
Received 4 January 2019; Received in revised form 4 February 2019; Accepted 8 February 2019
Available online 20 February 2019
1044-0283/ © 2019 Elsevier Inc. All rights reserved.
M.M. Cornett, et al. Global Finance Journal 41 (2019) 44–59
interaction for industries with similar concentration levels (Lyandres, 2006), we also create subsamples where industry firms compete
in strategic complements and strategic substitutes (Bulow, Geanakoplos, & Klemperer, 1985; Fudenberg & Tirole, 1984). When firms
compete in strategic complements, competitors match a firm's strategic move and thus escalate competition (examples of this “more
aggressive” strategy include lower price in price competition and greater quantity in quantity competition). With strategic sub-
stitutes, competitors act “less aggressively,” accommodating a firm's strategic move or even moving in the opposite direction (e.g.,
when one firm increases its output, competitors will lower their outputs in response).
We find an overall U-shaped relation between industry concentration and innovation for a large set of U.S. firms. It is important to
note that most studies use the complement of industry concentration as a measure of competition. If we make this assumption, a U-
shaped relation between industry concentration and innovation suggests an inverted U-shaped relation between competition and
innovation. However, as we explain later in the paper, industry concentration and competition are not always perfectly negatively
correlated. In addition to number and size of firms, strategic interaction among firms and productivity levels also affect the nature of
competition. Thus, we attempt to capture these factors separately, instead of using one measure of product market competition.
Subsample analysis reveals that the U-shaped relation between industry concentration and innovation is driven by neck-and-neck
industries. This is broadly consistent with Aghion et al. (2005), who find an inverted U-shaped relation between competition and
innovation for manufacturing firms in the U.K. Our results suggest that for neck-and-neck industries (where firms operate at similar
levels of productivity), when industry concentration is low (the industry has a large number of competitors) innovation intensity
decreases as industry concentration increases. However, when industry concentration is high (fewer competitors), increased industry
concentration is associated with an increase in innovation intensity.1 Increased concentration increases the incentive to invest in
innovation as a way to escape competition among fewer, but equally performing firms. In other words, under intense competition,
firms increase innovation intensity to differentiate their products from those of their equally productive rivals.
Subsample analysis based on the type of strategic interaction among industry firms finds that the U-shaped relation between industry
concentration and innovation is driven by industries where firms compete in strategic substitutes. When firms compete in strategic
substitutes, competitors accommodate a firm's strategic move or even move in the opposite direction. Thus, the U-shaped relation between
product market competition and innovation is accentuated. When firms compete in strategic complements, competitors match a com-
petitor's strategic move, and thus escalate competition. In this case, increased investment may be a strategic handicap, because it may
reduce the incentive to respond aggressively to competitors. Thus, product market competition is unrelated to innovation intensity.
A potential concern with our study design is that innovation may be endogenous with the competitive environment. To address
this concern, we conduct a quasi-natural experiment using tariff rate reductions as an exogenous shock to the competitive en-
vironment (Fresard, 2010; Valta, 2012). We find that firms in neck-and-neck industries respond to threats from foreign rivals by
increasing innovation. In contrast, firms in leader-laggard industries respond to these threats by decreasing innovation. Lower import
tariff rates facilitate the entrance of foreign rivals, which leads industries to become more asymmetric (i.e., leader-laggard) with
higher average productivity gap among industry firms. Consistent with our main results, as industries gravitate towards leader-
laggard product markets, innovation intensity decreases. We also find that, following large reductions in import tariff rates, in-
novation activity increases for firms that compete in strategic substitutes. After reductions in import tariff rates, industries change
from competing as strategic complements to competing in strategic substitutes. Incumbents competing in strategic substitutes make a
commitment to deter entry (i.e., “top dog” strategy) and overinvest in innovation.
2. Related literature and testable hypotheses
Research examining the relation between product market competition and innovation is extensive, but has yet to come to a consensus.
Early theoretical models (e.g., Schumpeter, 1942) argue that monopoly market power is more conducive to innovation than highly
competitive markets, while Salop (1977), Dixit and Stiglitz (1977), Romer (1990), and Aghion and Howitt (1992) predict that more intense
product market competition discourages innovation by reducing post-entry rents. Empirical literature that followed finds mixed results.
Scherer (1967) documents a concave (inverted-U shaped) relation between competition and innovation, while researchers using linear
specifications (e.g., Blundell et al., 1999; Geroski, 1990; Nickell, 1996 and Schmitz, 2005) find a positive linear relation.
More recently, Tishler and Milstein (2009) and Sacco and Schmutzler (2011) predict a convex (U-shaped) relation between
competition and innovation. Using oligopoly markets with Cournot competition, Tishler and Milstein (2009) find a convex relation
between competition and innovation that results from two opposing effects on the industry's R&D efforts: the strategic effect which
increases R&D efforts when competition intensifies and the reduction in market demand effect which leads to decline in R&D efforts
when competition becomes intense. The reduction in market demand effect dominates (reduces R&D more than the strategic effect
increases R&D) when the level of competition is low or moderate, while the strategic effect dominates when competition is intense.
The authors refer to the latter effect as “R&D war,” where under intense competition firms may spend excessively on R&D to
differentiate their products from those of their rivals. Sacco and Schmutzler (2011) consider a duopoly with Cournot competition. For
symmetric firms (with identical initial marginal costs), an increase in competition reduces investments as long as product differ-
entiation remains sufficiently strong. As products become sufficiently similar, however, an increase in competition raises investments.
1
Our results contrast with Hashmi (2013), who finds a monotone relation between competition and innovation for manufacturing firms in the U.S.
Unlike Hashmi (2013), we do not restrict the sample to manufacturing industries, which allows for the examination of a larger set of industries. We
also examine a more recent sample period (1987 to 2016 compared to 1976 to 2001 in Hashmi). In addition, unlike Hashmi, we include firm fixed
effects in addition to year and industry fixed effects.
45
This U-shape becomes even more pronounced for firms that are initially more efficient than their competitors. If a firm lags sub-
stantially behind a competitor, increasing intensity of competition has a negative effect on investments.
Aghion et al. (2005) attempt to theoretically and empirically reconcile Schumpeter's theory using publicly listed manufacturing
firms in the U.K. In their model, in sectors where firms operate at similar technological levels (neck-and-neck sectors) more com-
petition may increase the incremental profits from innovating, and thereby encourage R&D investments in order to escape compe-
tition. In sectors where some firms lead in technological innovation while others lag (leader-laggard sectors), competition, and the
cost of catching up with leaders by innovating, discourages laggard firms from innovating.2 This, in turn, causes leaders to no longer
innovate. The balance between these two effects changes between low and high levels of competition, generating an inverted-U
relationship. Hashmi (2013) examines the relation between competition and innovation using data from publicly traded manu-
facturing firms in the U.S. He finds a mildly negative relation between competition and innovation. Hashmi argues that the reason for
the difference in his results versus Aghion et al. is because U.K. manufacturing industries are technologically more neck-and-neck
than their U.S. counterparts, i.e., U.S. firms are less competitive. Thus, consistent with Schumpeter, less competitive industries are
more innovative, i.e., the relation is negative. Gilbert et al. (2017) extend the model of stepwise innovation by duopoly in Aghion
et al. (2005) to a model of stepwise innovation by oligopoly. They show that predictions of the effects of competition on innovation
from the duopoly models do not generalize to oligopolies.
Boone (2001) shows that the relation between innovation and competition is non-monotonic in an oligopolistic market.3 Boone
(2001) presents two main results. First, when intensity of competition is low, a less efficient firm has greater incentive to buy
innovation than a more efficient one. When it is high, a more efficient firm has the greater incentive to buy innovation. Second, the
relation between the intensity of competition and the incentive to innovate is non-monotone. This is due to the fact that changing the
intensity of competition changes the identity of the innovating firm and consequently the valuation of the innovation. Boone con-
cludes that when cost improvement is substantial, an increase in competitive pressure increases the value of the innovation. When
improvement in cost reduction is minor and competition in the product market is weak, increasing competition has an ambiguous
effect on the willingness to pay for innovation.
In sum, theory finds no simple monotone relation between competition and innovation. Depending on the specific assumptions
about the competitive environment, whether the setting is a duopoly or oligopoly, whether firms in an industry are symmetric
(leveled) or asymmetric (unleveled), whether laggards can leapfrog leaders or can only innovate stepwise, and whether the nature of
competition is Bertrand or Cournot, etc., predictions of theoretical models vary. Therefore, we echo the statement in Sacco and
Schmutzler (2011) that searching for a general relation between competition and innovation may be in vain. Rather, as we examine
in this paper, it may be more promising to identify the circumstances leading to each kind of relation.
Following Aghion et al. (2005) and Boone (2001), we hypothesize the following:
Hypothesis 1. The relation between industry concentration and innovation is convex (U-shaped) and is more pronounced in neck-
and-neck industries.
A challenge in such an empirical exercise is that the concept of product market competition cannot be measured directly. Studies
have used various proxies for the intensity of competition: number of firms in the industry (Arrow, 1962; Tirole, 1988), complement
of industry average price cost margin, i.e., Lerner Index, (Aghion et al., 2005), complement of industry concentration (Tirole, 1988),
degree of substitutability among differentiated products (Dixit & Stiglitz, 1977), reduction in unit transport cost (Salop, 1977) etc.,
and each proxy has its own advantages and disadvantages.4
The most widely used proxy for product market competition in the empirical finance literature is the industry concentration ratio
such as the Herfindahl-Hirschman Index (HHI) or four-firm concentration ratio (FFR) (e.g., Aslan & Kumar, 2016; Giroud & Mueller,
2011; Gu, 2016; Hou & Robinson, 2006; Phillips & Zhdanov, 2013). Usually, a high level of concentration is interpreted as weak
competition. However, Boone (2001) points out that this interpretation assumes symmetric firms (in terms of efficiency). With
asymmetric firms, high levels of competition imply that the most efficient firms can survive, resulting in high industry concentration.
Low levels of competition in such a setting imply that less efficient firms can still produce, resulting in a large number of firms. i.e.,
low industry concentration. Similarly, Tishler and Milstein (2009) suggest that the more intense the product market competition and
the smaller the number of firms at the beginning of the game, the more likely are weaker firms to be forced out of the market. On the
other hand, all firms in an oligopoly are likely to remain in the market if they exhibit similar strength (i.e., efficiency).5 Given the
conflicting interpretations, we avoid using the complement of the industry concentration ratio as a measure of product market
2
Firms in the model make discrete, stepwise improvements to their production technologies so the laggard must first catch up to the leader before
it can become the new leader.
3
Boone assumes that the R&D sector consists of several laboratories that engage in a race, the price of which is an infinitely lived patent on a cost-
reducing technology. The winner sells the patent to the highest bidder among firms in the industry. Laggards can leapfrog, in contrast to the stepwise
model in Aghion et al. (2005) where laggards must catch up to the leader first.
4
For example, the most important limitation of the Lerner Index, as summarized by Lindenberg and Ross (1981), is that the Lerner Index does not
recognize that some of the deviation of price from marginal cost comes from either the efficient use of scale or the need to cover fixed costs. This is a
significant limitation because few firms fit the textbook description of perfect competition. The cost structure of firms in many technology-driven
industries (e.g., software, pharmaceuticals) is markedly front-loaded. Marginal cost pricing in these industries is neither feasible nor desirable
(Elzinga & Mills, 2011).
5
Tishler and Milstein (2009) mention the consolidation of the wireless telecom industry in the U.S. as a good example of the effect of strong
competition with nearly homogeneous products characterized by very fast technological development.
46
competition, and instead look directly at the effect of industry concentration on innovation under various circumstances.6
We also look at the effect of strategic interactions on the relation between industry concentration and innovation intensity. While
high industry concentration usually means a scenario where a few large companies have very high market share, Lyandres (2006)
notes that high industry concentration could also be due to high variation in the sizes of industry participants, which reduces the
expected influence of firms' actions on their rivals. Similarly, industries with low concentration could consist of a large number of
similarly sized firms, which cannot affect one another's actions, or a few large firms and numerous small firms, where large firms'
choices can affect their large rivals' actions.
Therefore, we characterize product markets by strategic substitutes or strategic complements based on Fudenberg and Tirole (1984)
and Bulow et al. (1985). Intuitively, the idea of strategic complements is that competitors match a firm's strategic move, and thus escalate
competition (examples of this strategy include lowering price in price competition, producing greater quantity in quantity competition,
and increasing levels of advertising in response to greater advertising by rivals). With strategic substitutes, competitors move in the
opposite direction (e.g., when one firm increases its output, competitors lower their outputs in response). According to Bulow et al. (1985),
both quantity (Cournot) and price (Bertrand) competition can give either strategic complements or strategic substitutes.7
In classifying industries as “neck-and-neck” or “leader-laggard,” Aghion et al. (2005) assume that firms always match a rival's
move in innovation. Whether the innovation is made by neck-and-neck firms to escape competition or by laggard firms to catch up
with the leader firms, it always involves more spending in R&D. Their model focuses on Bertrand competition. Delbono and Denicolo
(1990) also show that firms tend to overinvest in R&D if there is Bertrand competition in product markets. However, under Cournot
competition firms can either overinvest or underinvest. Therefore, in industries where firms compete in strategic substitutes (re-
gardless of the mode of competition in the product market, Cournot or Bertrand), a firm's optimal response to increasing R&D
competition by a rival could be to keep its R&D investments unchanged or even decrease R&D. When firms compete in strategic
complements, increased investment may reduce the incentive to respond aggressively to competitors.
Thus, following Aghion et al. (2005) for Bertrand competition and Tishler and Milstein (2009) and Sacco and Schmutzler (2011)
for Cournot competition, we hypothesize the following:
Hypothesis 2. The convex relation between industry concentration and innovation is more pronounced in industries where firms
compete in strategic substitutes.
3. Empirical methodology
3.1. Data
The initial sample consists of all firms in Compustat Fundamentals (Annual and Quarterly) except financials, utilities, government
organizations, and not-for-profit organizations from 1987 to 2016. Following Fresard (2010), we exclude firms for which sales or
assets data are missing, negative, or zero; book equity is negative; and asset or sales growth are > 200%. We classify product markets
(industries) at the three-digit SIC code level. As pointed out by Clarke (1989), some four-digit SIC codes may fail to define sound
economic markets. The final sample consists of 66,141 firm-year observations, 8344 distinct firms, and 228 three-digit SIC code
industries. We winsorize all variables at the first and ninety-ninth percentiles to reduce the effect of outliers.
3.2. Measures of innovation intensity
The most commonly used measures of innovation intensity are R&D expenditures and patent activity. R&D is a measure of
innovative input, while patent activity measures innovative output. Following Thakor and Lo (2015), Brown, Fazzari, and Petersen
(2009), Bertrand and Schoar (2003), and Blonigen and Taylor (2000), we use R&D (Compustat item XRD) to Total Assets (Compustat
item AT) as a first measure of innovation. Firms are only required to report R&D expenditures when they are “material”
(usually > 1% of sales). Following previous studies, missing values in R&D are set to zero.
Patent activity is generally measured using citation-weighted patent counts (e.g., Aghion et al., 2005; Hall, Jaffe, & Trajtenberg, 2005;
Kogan, Papanikolaou, Seru, & Stoffman, 2017). Kogan et al. (2017) match the entire history of U.S. patent documents issued by the United
States Patent and Trademark Office (USPTO) (from Google Patents) from 1926 to 2010 to firms in the Center for Research in Security
Prices (CRSP) database. We use their database of 1.9 million matched patents to collect patent data (CW_Patents) for our sample firms. Of
the 5443 unique firms in their database, 4312 firms are in our sample, representing 25,004 firms-years from 1987 through 2010.
3.3. Measures of the competitive environment
3.3.1. Measures of industry level productivity gap

Following Aghion et al. (2005), we divide sample industries into leveled (neck-and-neck) and unleveled (leader-laggard) in-
dustries based on the size of the productivity gap between firms in an industry. Productivity gap (inefficiency) is the proportional
6
Thakor and Lo (2015) measure competition through concentration ratio as well.
7
For example, quantity competition and constant elasticity demand may yield strategic complements, but a linear demand curve with the same
elasticity around equilibrium always yields strategic substitutes.
47
distance a firm is from the efficient frontier, i.e., difference between productivity for the frontier firm and productivity for a particular
firm scaled by productivity for the frontier firm.8 We construct AVE_PGAP for each industry and year as the average productivity gap
across firms in the industry. Firms in industries with below median AVE_PGAP operate closer to the efficient frontier and are referred
to as leveled or neck-and-neck industries. An above median AVE_PGAP indicates firms in industries with a large gap with the efficient
frontier, referred to as unleveled or leader-laggard industries.
A problem with AVE_PGAP is that it does not pick up dispersion of productivity in a given industry. For example, the average
productivity gap in an industry can be low because of outliers in the industry and may not indicate that every firm is operating at the
same level of productivity. Thus, we also calculate the coefficient of variation of firm efficiency in the industry, or COV_EFF, as the
standard deviation of firm efficiency (i.e., productivity) divided by average firm efficiency for each industry and year. COV_EFF is a
standardized measure of the dispersion of productivity in a given industry. So, if two industries with similar standard deviation
(dispersion) of productivity have different average efficiency scores, COV_EFF will pick up this difference. For both measures, in-
dustries with below (above) median AVE_PGAP or COV_EFF are classed as neck-and-neck (leader-laggard) industries.
Firm level efficiency/productivity is measured using frontier efficiency methodology. Frontier efficiency methods (e.g., Aigner, Lovell, &
Schmidt, 1977; Charnes, Cooper, & Rhodes, 1978; Nguyen & Swanson, 2009) measure a particular firm's efficiency relative to a “best
practice” frontier derived from firms in the industry: those firms that produce the maximum output from a portfolio of inputs. Our measure of
performance is based on a firm's ability to fully (i.e., efficiently) utilize its resources. Two firms with similar characteristics and opportunity
sets should ideally have the same level of production, Y*. However, some firms do not use their resources as efficiently as others. Thus, a firm
may be at a production level Y, which is less than Y*. The difference between Y* and Y is firm inefficiency, or PGAP.
We follow Banker, Charnes, and Cooper (1984) and employ data envelopment analysis (DEA) with variable returns to scale
(VRS).9 VRS (the most widely used assumption for DEA) reflects the fact that production technology may exhibit increasing, constant,
and decreasing returns to scale. Given certain level of inputs and outputs, DEA compares each firm to its ‘best practice’ peers (by
industry and year) and provides an efficiency score from zero to one. A firm is classified as fully efficient (Efficiency = 1.0) if it lies on
the frontier and inefficient (0 < Efficiency < 1) if its outputs can be produced more efficiently by another set of firms.10
For inputs, we follow Demerjian, Lev, and McVay (2012) by considering items that contribute to the production of revenue. The
first input is net property, plant, and equipment (Compustat data item PPENT). The second input is capitalized operating leases,
calculated as the discounted (at 10%) present value of five years of lease payments. Compustat data items for the five lease ob-
ligations are MRC1, MRC2, MRC3, MRC4, and MRC5. The third input is the five-year capitalized value of R&D expense (XRD). The
0
capitalized value is calculated as: RDcap = (1 + 0.2t ) × RDt . The fourth input is purchased goodwill, calculated as the premium
t= 4
paid over the fair value of an acquisition (GDWL). The fifth input is other acquired and capitalized intangibles (INTAN – GDWL). The
sixth input is cost of goods sold (COGS). The final input is selling, general, and administrative costs (XSGA). Demerjian et al. (2012)
argue that the management team has a great deal of latitude in asset purchase and retirement decisions. Therefore, these seven inputs
capture choices managers make in generating revenue.
For output, also following Demerjian et al. (2012), we use revenue (Compustat data item SALE). Other papers (e.g., Habib &
Ljungqvist, 2005; Nguyen & Swanson, 2009) have used Tobin's Q or net income as measures of output. Using Tobin's Q, however, may
subject the efficiency measure to a potential misvaluation problem. That is, an irrational overvaluation of a firm's equity relative to its
fundamentals may make the firm appear more efficient than it is in reality. In addition, Demerjian et al. (2012) argue against net
income as an output since it is the aggregation of inputs and outputs (expenses and revenue). Lee and Choi (2010) show that the
inclusion of a redundant output variable (e.g., net income) does not significantly change the DEA efficiency estimates. The DEA linear
program measures a firm's ability to maximize output (revenue) given a certain level of inputs (costs). Therefore, firms that minimize
costs for a given level of revenue are more efficient, i.e., have a lower PGAP.
We measure efficiency for all firms in Compustat (excluding financials, utilities, government organizations, and not-for-profit
organizations) during fiscal years 1987–2016. To be included in the efficiency estimations, firms must have no missing data for all
input and output variables. Since we expect that firms in the same industry will have similar structures for converting capital into
revenue, we estimate efficiency separately for each industry and year. This allows cost functions to differ across industries. We obtain
a measure of efficiency for 192,899 firm-years. Although our final sample is smaller due to additional data requirements, we compute
firm efficiency on as large a possible set of firms since it is the universe of firms that determines the ‘best practice’ frontier.
3.3.2. Measures of the degree of strategic interaction

Sundaram, John, and John (1996) develop a proxy (denoted competitive strategy measure or CSM) for whether firms compete in
strategic complements or strategic substitutes. Kedia (2006) and Lyandres (2006) modify this empirical proxy to control for the effect
of industry shocks. Following Lyandres (2006) we estimate CSM such that for a given firm i, CSM is defined as:
8
We can also refer to productivity gap as a measure of inefficiency.
9
Two prominent frontier efficiency methodologies exist: (i) parametric or stochastic frontier analysis (SFA), which generally makes assumptions
about the functional form of the production function and error term distributions, and estimates efficiency using econometric techniques; and (ii)
non-parametric techniques, e.g., DEA, which do not make assumptions about functional forms and estimate efficiency using mathematical (linear)
programming. In empirical studies, the DEA approach has been most frequently used (Eling & Luhnen, 2010).
10
DEA efficiency estimates are known to be biased upward in finite samples (e.g., Simar & Wilson, 1998). To correct the upward bias of our
efficiency estimates, we implement the bootstrapping procedure of Simar and Wilson (1998) with 2000 bootstrap replications by using rDEA, a
package for frontier efficiency analysis in R (Simm & Besstremyannaya, 2016).
48
i
CSMi = corr , SR ,
Si (1)
11
where i and Si are the implied changes (between two consecutive quarters) in the profits and sales of firm i, respectively, and
ΔSR is the change in the firm's product market rivals' combined sales between two consecutive quarters. Lyandres (2006) shows that
using implied changes (which takes into account changes in industry average profit margins), rather than actual changes in profits
and sales (i.e., i and Si rather than Δπi and ΔSi), reduces the bias in CSM that can result from industry shocks. CSMi is used as a
proxy for the cross-partial derivative of a firm's profit with respect to its own and its rivals' sales. We then define industry CSM as the
mean CSMi for all firms in a given industry.
Finally, recognizing that a positive CSM corresponds to firms' strategies being strategic complements, while a negative CSM
describes the case of competition in strategic substitutes, Lyandres uses the absolute value of CSM, |CSM|, to capture the extent of
strategic interaction, regardless of the type of strategic interaction. A higher value of |CSM| reflects higher strategic interaction
among industry competitors. We also measure the type of strategic interaction and classify firms into industries with a positive CSM
(firms compete in strategic complements) and industries with a negative CSM (firms compete in strategic substitutes). In industries
where firms compete in strategic complements, competitors match a firm's strategic move and thus escalate competition. With
strategic substitutes, competitors accommodate a firm's strategic move and thus act complaisantly (a “less aggressive” strategy).
Intuitively, the idea of strategic complements is that competitors match a firm's strategic move in the same direction. Examples of this
strategy include lowering price in price competition, producing greater quantity in quantity competition, and increasing levels of
advertising in response to greater advertising by rivals. With strategic substitutes, competitors move in the opposite direction (e.g.,
when one firm increases its output, competitors lower their outputs in response).
3.3.3. Industry concentration

We collect Compustat-based concentration ratios (Herfindahl-Hirschman Index (HHI) and four-firm concentration ratio (FFR)) as two
measures of industry concentration. However, Ali, Klasa, and Yeung (2009) show that measures of industry concentration that rely solely on
Compustat firms may lead to incorrect conclusions due to the omission of private firms from the computation. As a third measure of industry
concentration, we use Census of Manufactures publications, provided by the U.S. Census Bureau.12 For the period 1997–2016, census-based
concentration ratios use 3-digit North American Industry Classification System (NAICS) and are computed for hundreds of industries con-
structed using data from all public and private firms in the industries. We collect data on the U.S. Census-based FFR (CFFR) which should
more fully capture actual industry concentration. Since the Census of Manufactures is published only once every five years, we use 1997,
2002, 2007, and 2012 CFFR for the periods 1997–2001, 2002–2006, 2007–2011, and 2012–2016, respectively. This approach is similar to
that used in several prior studies (e.g., Giroud & Mueller, 2011). For all three measures, higher values depict higher industry concentration.
4. Empirical analysis
4.1. Descriptive statistics
Table 1 lists descriptive statistics for our variables. Panel A reports data for firm-level variables and Panel B for industry-level
variables. Financial statement data are from Compustat. R&D to Total Assets is the ratio of R&D expenditures (Compustat item XRD) to
book value of total assets (item AT). CW_Patents is citation-weighted patent counts from Kogan et al. (2017). Efficiency is the bias-
corrected DEA firm efficiency measure. Firm Age is from the Center for Research in Security Prices (CRSP) database and is the number
of years firms are present in CRSP. NPPE to Total Assets is net property, plant, and equipment (item PPENT) to total assets. Cash to
Total Assets is cash and short-term investments (item CHE) to total assets. Book leverage is total debt (items DLTT + DLC) to total
assets. Market-to-Book is the market value of total assets (items AT − CEQ + PRCC_F* CSHPRI) to total assets. FCF to Total Assets is
(net cash flow from operating activities (item OANCF) minus capital expenditures (item CAPX)) to total assets.
The mean (median) R&D to Total Assets is 8.15% (3.85%). Because many firms report no R&D, the distribution is skewed.13 The
distribution of CW_Patents has a mean (median) of 83 (9) and is also skewed. Thus, in regression analysis we use ln(R&D to Total
Assets) and ln(CW_Patents). The mean (median) efficiency for the sample firms is 0.6963 (0.7628). While the average efficiency is
similar to the average value reported in Demerjian et al. (2012),14 the median value is higher. Finally, from Panel A, total assets for
the sample averages $3.44 billion (ranging from $40,000 to $479.92 billion) and the mean (median) firm age is 13 (10) years.
11
Implied changes in profits and sales are estimated by following equations (8), (9), and (10) in Lyandres (2006), using the previous 20 quarters
(requiring at least 10 observations for each regression), which are then used to estimate CSMi (as defined in Eq. (1)) for each firm-year in a given
industry. We obtain CSM (the mean of CSMi) for each year and industry.
12
Census of Manufactures publications report FFRs for most industries and HHIs only for manufacturing industries. Accordingly, we use the
Census-based FFR to include more industries in our analysis.
13
We also collect R&D to Sales as an alternate for R&D to Total Assets. The distribution for this ratio is even more skewed (mean (median) value is
33.26% (4.10%)). Therefore, we use R&D to Total Assets for all our tests.
14
Demerjian et al. (2012) report an average (median) efficiency score of 0.60 (0.59). However, we note that firm efficiency estimates of Demerjian
et al. (2012) are not directly comparable to our estimates for two reasons. First, Demerjian et al. estimate efficiency by Fama-French industry, while
we use 3-digit SIC code industry. Second, Demerjian et al. estimate efficiency by industry over their full sample period, while we measure efficiency
by industry for each year of our sample.
49
Table 1
Descriptive statistics.
This table reports descriptive statistics on the sample. Financial statement data are from Compustat from 1987 to 2016. Panel A reports firm-level
variables. R&D to Total Assets is the ratio of R&D expenditures (Compustat item XRD) to total assets (item AT). Missing values in R&D expenditures
are set to zero. CW_Patents is a citation-weighted patent count from Kogan et al. (2017). Efficiency is the bias-corrected DEA firm efficiency measure.
Total Assets is the book value of total assets. Firm Age is the number of years firms are present in CRSP. NPPE to Total Assets is net property, plant, and
equipment (item PPENT) to total assets. Cash to Total Assets is cash and short-term investments (item CHE) to total assets. Book Leverage is total debt
(items DLTT + DLC) to total assets. Market-to-Book is market value of total assets (items AT − CEQ + PRCC_F*CSHPRI) to total assets. FCF to Total
Assets is (net cash flow from operating activities (item OANCF) minus capital expenditures (item CAPX)) to total assets. Panel B lists industry-level
variables by 3-digit industry code and year. AVE_PGAP is the average difference between the efficiency score for the frontier firm and a particular
firm scaled by the efficiency score for the frontier firm. COV_EFF is the coefficient of variation in efficiency scores measured as the standard
deviation of PGAP divided by AVE_PGAP for each industry and year. CSM is a competitive strategy measure that represents average responsiveness
of firms' profits to changes in their competitors' actions. HHI and FFR are Compustat-based Herfindahl-Hirschman Index and four-firm concentration
ratios. CFFR is a Census-based four-firm concentration ratio. No_Acquisitions is a count of completed acquisitions in an industry from SDC.
N Mean Median Std dev Min Max
Panel A – firm-level variables

R&D to total assets (%) 66,141 8.15 3.85 11.17 0.00 54.58
CW_Patents 25,004 83 9 379 1 10,162
Efficiency 63,861 0.6963 0.7628 0.2539 0.0001 1.0000
Total assets ($ millions) 66,141 3443.81 159.73 17,825.78 0.04 479,921.00
Firm_Age (years) 66,141 13 10 11 0 54
NPPE to total assets (%) 66,141 22.53 17.19 18.78 0.73 90.56
Cash to total assets (%) 66,141 22.79 14.50 22.93 0.01 87.60
Book leverage (%) 66,141 17.30 13.05 17.47 0.00 72.69
Market-to-book (%) 66,141 210.90 56.00 161.81 55.18 925.79
FCF to total assets (%) 66,141 −3.57 1.62 20.11 −88.24 27.46
Panel B – industry-level variables

AVE_PGAP 65,592 0.2348 0.2028 0.1868 0.0000 0.9421
COV_EFF 65,519 0.2575 0.1983 0.2461 0.0000 2.9332
CSM 66,141 −0.0495 −0.0487 0.1725 −0.8464 0.6230
HHI 66,141 0.1467 0.1030 0.1309 0.0318 1.0000
FFR 66,141 0.5790 0.5534 0.1970 0.2533 1.0000
CFFR 42,670 0.1738 0.1560 0.1146 0.0160 0.8800
No_Acquisitions 66,141 46 20 73 0 326
From Panel B, both AVE_PGAP and COV_EFF measure average productivity gap. The mean and median values for the two measures
are similar: mean (median) value for AVE_PGAP is 0.2348 (0.2028) and for COV_EFF is 0.2575 (0.1983). However, AVE_PGAP ranges
from 0.0000 to 0.9421, while COV_EFF ranges from 0.0000 to 2.9332. Thus, COV_EFF has a wider distribution. The mean (median)
industry-level CSM is −0.0495 (−0.0487), ranging from −0.8464 to 0.6230. The negative mean and median suggest that there are
more industries where firms compete as strategic substitutes than as strategic compliments. The mean (median) HHI for the sample
industries is 0.1467 (0.1030). Similarly, the mean (median) FFR for the full sample is 0.5790 (0.5534). Both values are much higher
than the Census-based FFR (CFFR) where the mean (median) value is 0.1738 (0.1560) (the difference is statistically significant at 1%
level). These differences are not surprising given that CFFR includes both public and private firms in the industry, while Compustat-
based FFR includes only public firms. No_Acquisitions is a count of completed acquisitions by industry firms, collected from the Securities
Data Company (SDC) database for each industry and year. The mean (median) for No_Acquisitions is 46 (20), ranging from 0 to 326.
Table 2 shows mean innovation intensity and efficiency levels for various subsamples based on product market competition,
strategic interaction, and industry concentration. Both measures of innovation intensity are lower for neck-and-neck industries
(where firms operate at similar productivity levels, below median productivity gap) than for leader-laggard industries (where some
firms lead in productivity while others lag, above median productivity gap). For example, the mean R&D to Total Assets (using
COV_EFF as the measure of innovation) is 0.0398 for neck-and-neck industries and 0.1239 for leader-laggard industries (significantly
different at 1%). Innovation is greater when there is a bigger discrepancy in productivity across industry firms, i.e., some firms are
very productive while others are not. Also, average efficiency for firms in neck-and-neck industries is significantly higher than
average efficiency for firms in leader-laggard industries.
Table 2 also shows that industries in which firms compete as strategic substitutes have significantly higher R&D to Total Assets
(mean is 0.0844) than industries in which firms compete as strategic compliments (mean is 0.0769) (significantly different at 1%).
Firms compete in strategic substitutes when an aggressive strategy by a firm lowers its competitor's marginal profits. Firms counteract
this by committing to invest in R&D. When firms compete in strategic complements, increased investment may be a strategic han-
dicap, because it may reduce the incentive to respond aggressively to competitors. No significant difference is seen with CW_Patents.
Finally, R&D to Total Assets is higher for firms in industries with low concentration when industry concentration is measured as
Compustat-based HHI (0.1174 vs 0.0459) or FFR (0.1187 vs 0.0444), both significantly different at 1%. No significant difference is
seen with CW_Patents. However, both measures of innovation intensity are significant using Census-based FFR (CFFR) that includes
public and private firms and the relation is reversed. R&D to Total Assets is lower for firms in industries with low concentration
(0.0817 vs 0.0854 using R&D to Total Assets and 19.1364 vs 49.2966 using CW_Patents, both significantly different at 1%). These
50
Table 2
Innovation intensity and efficiency by subsamples.
This table reports average innovation intensity and efficiency scores for various subsamples. R&D to Total Assets is the ratio of R&D expenditures to total
assets. CW_Patents is a citation-weighted patent count from Kogan et al. (2017). Efficiency is the bias-corrected DEA firm efficiency measure. AVE_PGAP is the
average difference between the efficiency score for the frontier firm and a particular firm scaled by the efficiency score for the frontier firm. COV_EFF is the
standard deviation of PGAP divided by AVE_PGAP for each industry and year. Neck-and-Neck (Leader-Laggard) industries are those with below (above)
median AVE_PGAP or COV_EFF. CSM is a competitive strategy measure that represents average responsiveness of firms' profits to changes in their competitors'
actions. Strategic substitutes (strategic complements) industries are those with CSM < 0 (> 0). HHI and FFR are Compustat-based Herfindahl-Hirschman
Index and four-firm concentration ratios. CFFR is the Census-based four-firm concentration ratio. Significance at 1% is indicated by ***.
Mean R&D to total assets t-Test Mean CW_Patents t-Test Mean efficiency t-Test
Neck-and-neck (COV_EFF) 0.0398 24.2705 0.8569

Leader-laggard (COV_EFF) 0.1239 *** 37.4202 *** 0.5287 ***
Neck-and-neck (AVE_PGAP) 0.0369 24.3694 0.8584
Leader-laggard (AVE_PGAP) 0.1267 *** 37.2761 *** 0.5277 ***
Strategic substitutes 0.0844 29.5763 0.6816 ***
Strategic complements 0.0769 *** 32.5343 0.7206
HHI < median 0.1174 31.4629 0.6003
HHI > median 0.0459 *** 29.9392 0.7911 ***
FFR < median 0.1187 30.9063 0.5947
FFR > median 0.0444 *** 30.4913 0.7971 ***
CFFR < median 0.0817 19.1364 0.6658
CFFR > median 0.0854 *** 49.2966 *** 0.6827 ***
Table 3
Correlations between innovation intensity and industry concentration.
This table reports pairwise correlations between innovation intensity and industry concentration. R&D to Total Assets is the ratio of R&D ex-
penditures to book value of total assets. CW_Patents is a citation-weighted patent count from Kogan et al. (2017). AVE_PGAP is the average difference
between the efficiency score for the frontier firm and a particular firm scaled by the efficiency score for the frontier firm. COV_EFF is the standard
deviation of PGAP divided by AVE_PGAP for each industry and year. CSM is a competitive strategy measure that represents average responsiveness
of firms' profits to changes in their competitors' actions. HHI and FFR are Compustat-based Herfindahl-Hirschman Index and four-firm concentration
ratios. CFFR is the Census-based four-firm concentration ratio. p-Values are presented in parentheses.
ln(R&D to total assets) ln(CW_Patents) AVE_PGAP COV_EFF CSM HHI FFR CFFR
ln(R&D to total assets) 1.0000
ln(CW_Patents) 0.0882 1.0000

(0.000)
AVE_PGAP 0.4949 0.0541 1.0000
(0.000) (0.000)
COV_EFF 0.4264 0.0376 0.9401 1.0000
(0.000) (0.000) (0.000)
CSM −0.0090 0.0071 −0.0525 0.0352 1.0000
(0.021) (0.070) (0.000) (0.000)
HHI −0.2735 −0.0341 −0.3985 −0.3035 0.0885 1.0000
(0.000) (0.000) (0.000) (0.000) (0.000)
FFR −0.3764 −0.0401 −0.5643 −0.4539 0.1064 0.8420 1.0000
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
CFFR −0.0918 −0.0118 −0.0771 −0.0781 0.0392 0.0696 0.0439 1.0000
(0.000) (0.015) (0.000) (0.000) (0.000) (0.000) (0.000)
differences are not surprising given that CFFR includes public and private firms in each industry.
Table 3 reports pairwise correlation coefficients between innovation measures and industry concentration variables. R&D to Total
Assets and CW_Patents are both positively correlated with product market competition (for AVE_PGAP, 0.4949 and 0.0541, respectively,
and COV_EFF, 0.4264 and 0.0376, respectively). These are consistent with Table 2 where innovation intensity is higher for above
median productivity gap (leader-laggard) and lower for below median productivity gap (neck-and-neck) industries. R&D to Total Assets
negatively correlated with strategic interaction, CSM, (−0.0090), i.e., R&D to Total Assets is higher in industries where firms compete as
strategic compliments. Finally, innovation intensity is negatively correlated with HHI and FFR, i.e., low industry concentration results in
higher innovation. Table 3 also suggests that productivity gap is negatively correlated with industry concentration, i.e., industry
concentration is higher for below median productivity gap (neck-and-neck industries where firms have similar PGAP) and lower for
above median productivity gap (leader-laggard industries where firms have large gaps in productivity) industries.
4.2. Regression analysis
To test the relation between innovation intensity and industry concentration in a multivariate setting, we estimate the following
51
Table 4
R&D intensity and industry concentration.
This table reports results for regressions showing the impact of industry concentration on R&D intensity for 1987–2016. The dependent variable is
ln(R&D to Total Assets). Neck-and-neck (leader-laggard) industries are those with below (above) median COV_EFF. Strategic substitutes (strategic
complements) industries are those with CSM < 0 (> 0). Control variables include ln(Inflation-adjusted Total Assets), ln(Firm Age), NPPE to Total
Assets, Cash to Total Assets, Book Leverage, Market-to-Book, FCF to Total Assets, and No_Acquisitions. Estimation (1) includes the full sample, (2) and (3)
report results for neck-and-neck and leader-laggard industries, respectfully, and (4) and (5) report results for strategic substitutes and strategic
complements, respectfully. All regressions include firm, industry, and year fixed effects. Standard errors adjusted for within-firm clustering are listed
in parentheses. Significance at 10%, 5%, and 1% is indicated by *, **, and ***, respectively.
(1) (2) (3) (4) (5)
All Neck-and-neck Leader-laggard Strategic substitutes Strategic complements
Panel A: Regressions of R&D/total assets on HHI

HHI −0.026*** −0.027*** −0.011 −0.018 −0.009
(0.01) (0.01) (0.02) (0.01) (0.01)
HHI2 0.028*** 0.027*** 0.025 0.021 0.010
(0.01) (0.01) (0.02) (0.01) (0.01)
Constant 0.108*** 0.036** 0.177*** 0.061 0.130***
(0.02) (0.02) (0.01) (0.06) (0.02)
Controls Yes Yes Yes Yes Yes
Firm FE Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes
Adjusted R2 0.26 0.10 0.33 0.25 0.25
No. observations 66,141 31,697 33,822 41,044 25,097
Panel B: Regressions of R&D/total assets on FFR

FFR −0.045*** −0.055*** −0.027 −0.030 −0.041*
(0.02) (0.02) (0.02) (0.02) (0.02)
FFR2 0.025** 0.030*** 0.015 0.016 0.025
(0.01) (0.01) (0.02) (0.01) (0.02)
Constant 0.123*** 0.055*** 0.188*** 0.074 0.144***
(0.02) (0.02) (0.01) (0.06) (0.02)
Adjusted R2 0.26 0.10 0.33 0.26 0.25
No. observations 66,141 31,697 33,822 41,044 25,097
Panel C: Regressions of R&D/total assets on CFFR

CFFR −0.113*** −0.063** −0.115** −0.149*** 0.003
(0.03) (0.02) (0.05) (0.04) (0.04)
CFFR2 0.132*** 0.077*** 0.091 0.178*** 0.030
(0.03) (0.03) (0.08) (0.05) (0.04)
Constant 0.150*** 0.087*** 0.215*** 0.174*** 0.135***
(0.01) (0.01) (0.01) (0.01) (0.01)
Adjusted R2 0.30 0.15 0.35 0.30 0.28
No. observations 42,670 19,833 22,630 26,046 16,624
regression:
2
Innovationi, j, t = 0 + 1 CRj, t + 2 CRj, t + Controlsi, j, t + i + j + µt + i, j, t (2)
where i, j and t denote firm, industry, and year, respectively. Innovationi,j,t is either ln(R&D to Assets) or ln(CW_Patents). CR is industry
concentration using HHI, FFR, or CFFR. Given previous findings of an inverted-U (or more generally, non-monotone) relationship
between competition and innovation intensity, we include both CR and CR2 in the regressions. Controls include firm-level variables
(e.g., ln(inflation-adjusted15 Total Assets), ln(Firm Age), NPPE to Total Assets, Cash to Total Assets, Book Leverage, Market-to-Book, FCF to
Total Assets) that are known to be determinants of innovative activity,16 and industry-level No_Acquisitions that has been found to be
an important driver of innovation intensity (Phillips & Zhdanov, 2013). We include firm fixed effects (δi), industry fixed effects (ηj),
15
Inflation is measure as the Consumer Price Index (CPI) obtained from the Federal Reserve's website, www.federalreserve.gov.
16
Brown et al. (2009) find significant effects of cash flow and external equity for young, but not mature, high-tech firms. Hirschey et al. (2012)
find that time invariant firm and industry fixed effects explain most of the cross-sectional variation in observed R&D spending.
52
Table 5
CW_Patents and industry concentration.
This table reports results for regressions showing the impact of industry concentration on CW_Patents for 1987–2016. The dependent variable is ln
(CW_Patents). Neck-and-neck (leader-laggard) industries are those with below (above) median COV_EFF. Strategic substitutes (strategic comple-
ments) industries are those with CSM < 0 (> 0). Control variables include ln(Inflation-adjusted Total Assets), ln(Firm Age), NPPE to Total Assets,
Cash to Total Assets, Book Leverage, Market-to-Book, FCF to Total Assets, and No_Acquisitions. Estimation (1) includes the full sample, (2) and (3) report
results for neck-and-neck and leader-laggard industries, respectfully, and (4) and (5) report results for strategic substitutes and strategic comple-
ments, respectfully. All regressions include firm, industry, and year fixed effects. Standard errors adjusted for within-firm clustering are listed in
parentheses. Significance at 10%, 5%, and 1% is indicated by *, **, and ***, respectively.
(1) (2) (3) (4) (5)
Panel A: Regressions of CW_Patents on HHI

HHI −0.740** −0.322 −0.259 −0.504 −0.873
(0.34) (0.43) (0.57) (0.39) (0.55)
HHI2 0.868* 0.389 0.092 0.624 0.691
(0.44) (0.57) (0.98) (0.55) (0.72)
Constant 1.714*** −0.411 0.870*** 1.051*** 0.139
(0.46) (0.42) (0.29) (0.31) (0.34)
Adjusted R2 0.08 0.09 0.04 0.08 0.09
No. observations 25,004 11,985 12,801 15,616 9388
Panel B: Regressions of CW_Patents on FFR

FFR −1.477*** 0.468 −0.084 −2.467*** −0.953
(0.57) (0.79) (0.85) (0.67) (0.79)
FFR2 0.914** −0.432 −0.103 1.705*** 0.468
(0.43) (0.57) (0.76) (0.51) (0.61)
Constant 2.178*** −0.556 0.926*** 1.943*** 0.447
(0.48) (0.52) (0.36) (0.40) (0.42)
Adjusted R2 0.08 0.09 0.04 0.09 0.09
No. observations 25,004 11,985 12,801 15,616 9388
Panel C: Regressions of CW_Patents on CFFR

CFFR −6.502*** −4.296*** −5.887** −8.100*** −5.175**
(1.39) (1.55) (2.43) (2.15) (2.02)
CFFR2 7.037*** 4.885** 4.053 8.612*** 6.167**
(1.94) (2.11) (4.00) (3.08) (2.71)
Constant 2.004*** 0.909 0.868** 1.648*** 2.100***
(0.47) (0.56) (0.36) (0.36) (0.77)
Adjusted R2 0.04 0.06 0.04 0.04 0.03
No. observations 15,577 7702 7830 10,012 5565
and year fixed effects (μt) in each regression. Standard errors are robust to heteroskedasticity and are clustered by firm.
Tables 4 and 5 show the results. The dependent variable in Table 4 is ln(R&D to Total Assets) and in Table 5 is ln(CW_Patents).
Column (1) in both tables reports results for the overall sample, columns (2) and (3) report results for neck-and-neck and leader-
laggard industries, respectively, and columns (4) and (5) report results for industries that compete in strategic substitutes and
strategic complements, respectively. Neck-and-neck (leader-laggard) industries are industries where COV_EFF is below (above) the
sample median. Firms in industries with below (above) median productivity gap operate closer to (further from) the efficient frontier.
Industries are defined as strategic substitutes (strategic complements) if industry average CSM is negative (positive). In industries
where firms compete in strategic complements, competitors match a firm's strategic move and thus escalate competition. With
strategic substitutes, competitors accommodate a firm's strategic move. In both tables, the measure of industry concentration is HHI
in Panel A, FFR in Panel B, and CFFR in Panel C.
Column 1 of Tables 4 and 5 shows that, regardless of the measure used, there is a U-shaped relation between industry con-
centration and innovation. For example, the coefficient on HHI in Table 4, Panel A is −0.026 and on HHI2 is 0.028. The linear and
quadratic terms are individually significant at 1% and jointly significant at 5%. Similarly, the coefficient on CFFR in Table 5, Panel C
is −6.502 and on CFFR2 is 7.037. The linear and quadratic terms are individually and jointly significant at 1%. This is broadly
53
35
30
25
20
15
10
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2003 2004 2005
Fig. 1. Distribution of tariff rate reductions between 1990 and 2005.

This figure shows large tariff rate reductions between 1990 and 2005. Following Fresard (2010) and Valta (2012), we calculate the industry-year ad
valorem tariff rate as duties collected at U.S. customs divided by the Free-on-Board custom value of imports. We compare tariff rate reductions in a
given industry-year to the industry's median change over the period of 1990–2005. We define a significant tariff reduction for a specific industry-
year as one in which the negative change in tariff rates is three times larger than the industry median change. To ensure that tariff cuts truly reflect
non-transitory changes in the competitive environment, we exclude tariff rate cuts that are followed by equivalently large tariff rate increases.
Further, we require industries with large tariff rate cuts to have three years of data before and after the rate reduction.
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Fig. 2. Average tariff rates for industries that do not experience large tariff rate cuts.
This figure shows the average tariff rate (%) for industries that do not experience large tariff rate reductions. Following Fresard (2010) and Valta
(2012), we calculate the industry-year ad valorem tariff rate as duties collected at U.S. customs divided by the Free-on-Board custom value of
imports. We compare tariff rate reductions in a given industry-year to the industry's median change over the period of 1990–2005. We define a
significant tariff reduction for a specific industry-year as one in which the negative change in tariff rates is three times larger than the industry
median change. To ensure that tariff cuts truly reflect non-transitory changes in the competitive environment, we exclude tariff rate cuts that are
followed by equivalently large tariff rate increases.
consistent with Aghion et al. (2005) who find an inverted U-shaped relation between competition and citation-weighted patents.
To explore this relation further and test Hypothesis 1, we focus on subsample analyses in columns 2 and 3 of Tables 4 and 5.
Consistent with Hypothesis 1, the overall U-shaped relation between industry concentration and innovation is driven by neck-and-neck
industries: the coefficients on the linear and quadratic terms on industry concentration are all statistically significant at 5% level or
higher. For example, the coefficient on HHI in regression 2 of Table 4, Panel A is −0.027 and on HHI2 is 0.027. The linear and quadratic
terms are individually and jointly significant at 1%. However, the coefficient on HHI in regression 3 of Table 4, Panel A is −0.011 and
on HHI2 is 0.025 (both are insignificant). Neck-and-neck industries are those where firms have similar PGAP. Results suggest that for
these equally productive firms, when industry concentration is low (the industry has many competitors), innovation intensity actually
54
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-2 -1 0 1 2
Fig. 3. Average tariff rates for industries that experience large tariff rate cuts.
This figure shows the average tariff rate (%) for industries that experience large tariff rate reductions. Following Fresard (2010) and Valta (2012),
we calculate the industry-year ad valorem tariff rate as duties collected at U.S. customs divided by the Free-on-Board custom value of imports. We
compare tariff rate reductions in a given industry-year to the industry's median change over the period of 1990–2005. We define a significant tariff
reduction for a specific industry-year as one in which the negative change in tariff rates is three times larger than the industry median change. To
ensure that tariff cuts truly reflect non-transitory changes in the competitive environment, we exclude tariff rate cuts that are followed by
equivalently large tariff rate increases. Further, we require industries with large tariff rate cuts to have three years of data before and after the rate
reduction.
Table 6
Industry concentration changes around large reductions in tariff rates.
This table reports average values of industry concentration variables for industries that experience large tariff cuts over the two years before and
after the year of the tariff rate reduction (−2,+2). AVE_PGAP is the average difference between the efficiency score for the frontier firm and the
efficiency score for a particular firm, scaled by the efficiency score for the frontier firm. COV_EFF is the standard deviation of PGAP divided by
AVE_PGAP for each industry and year. CSM is a competitive strategy measure that represents average responsiveness of firms' profits to changes in
their competitors' actions. HHI and FFR are Compustat-based Herfindahl-Hirschman Index and four-firm concentration ratios. CFFR is a Census-
based four-firm concentration ratio.
t AVE_PGAP COV_EFF CSM HHI FFR CFFR
−2 0.2212 0.2424 0.0605 0.1414 0.5787 0.3565

−1 0.2312 0.2549 0.0443 0.1423 0.5798 0.2814
0 0.2536 0.2573 0.0596 0.1322 0.5578 0.2553
+1 0.2512 0.2550 −0.0262 0.1296 0.5587 0.2768
+2 0.2827 0.3006 −0.0462 0.1270 0.5431 0.1577
decreases as concentration increases. However, at some point increased industry concentration (fewer competitors, operating at similar
levels of productivity) causes industry firms to increase innovation intensity. Increased concentration increases the incentive to invest in
innovation activities as a way to escape competition among fewer, but equally performing firms, i.e., under intense competition, firms
may spend excessively on R&D in order to differentiate their products from those of their equally productive rivals. The results are
significant in Table 5 only for CFFR, i.e., when innovation intensity is measured using patent activity, the changing relation between
industry concentration and innovation is seen only when both public and private firms are included in the sample.
In leader-laggard industries, where the productivity gap between firms is high, industry concentration seems to have no effect on
innovation intensity. In this case, some firms lead and others lag in productivity. Thus, there is no incentive to spend excessively on R&D
in order to outperform already underperforming firms or to differentiate products from those of better performing firms. The exception
to this is when industry concentration is measured as CFFR (including both public and private firms). In this case, we find a linear and
negative effect of industry concentration on innovation intensity. For example, the coefficient on CFFR in Panel C of Table 4 is −0.115
(significant at 5%), i.e., the more concentrated the industry the less innovation occurs by both leaders and laggards.
Columns 4 and 5 in Tables 4 and 5 report regressions for firms in industries with negative CSM (firms compete in strategic
substitutes) and positive CSM (firms compete in strategic complements). For the most part, we do not observe a significant relation.
However, results in Panel C of both tables, where we include industry concentration using both public and private firms, are sup-
portive of Hypothesis 2. For example, in Table 4, coefficients on CFFR and CFFR2 are negative (−0.149) and positive (0.178),
respectively, and both are significant at 1%. In Table 5, we see U-shaped relation between industry concentration and CW_Patents, but
the U-shape appears steeper for industries where firms compete in strategic substitutes. The coefficients on CFFR and CFFR2 are
55
negative (−8.100) and positive (8.612), respectively, in Panel C, regression 4 and are negative (−5.175) and positive (6.167),
respectively, in regression 5. However, across regression 4 and 5, the differences between regression coefficients are not significant.
When firms compete in strategic substitutes, competitors accommodate a firm's strategic move or even move in the opposite di-
rection. Thus, the U-shaped relation between product market competition and innovation is accentuated.
4.3. Quasi-natural experiment: reductions of import tariffs
It is quite possible that product market competition does not drive innovative intensity in firms, but the contrary, i.e., in-
novative intensity leads to very specific behaviors in product market competition. To address the potential endogeneity of product
market competition, we conduct a quasi-natural experiment. Specifically, we examine the effect of unexpected variations in in-
dustry import tariff rates on innovation intensity. According to the literature on barriers to trade, globalization of economic
activities and trade openness brings major changes in the competitive configuration of industries (Tybout, 2003). In particular, the
lessening of trade barriers triggers significant intensification of competitive pressures from foreign rivals (Bernard, Jensen, &
Schott, 2006). Recently, several papers use tariff reductions to measure exogenous shocks to the competitive environment (e.g.,
Fresard, 2010; Valta, 2012).
Following Aghion et al.'s (2005) finding that more competition may foster innovation for firms operating at similar productivity
levels, we conjecture that firms in neck-and-neck industries increase innovation intensity in response to threats by foreign rivals.
Additionally, Fudenberg and Tirole (1984) find that firms make strategic commitments to deter entry from foreign rivals. When firms
compete in strategic substitutes, incumbents make a tough commitment to deter entry (“top dog” strategy) and overinvest in in-
novation. When firms compete in strategic complements, incumbents make a soft commitment to deter entry (“lean and hungry
look”) and underinvest in innovation. Thus, we conjecture that intensification of competitive pressures from foreign rivals in the form
of reduced import tariffs leads to more (less) innovation in industries where firms compete in strategic substitutes (complements).
To measure reductions in import tariff rates at the 3-digit SIC industry level, we use import data compiled by Feenstra (1996),
Feenstra, Romalis, and Schott (2002), and Schott (2010), available from Peter Schott's website http://faculty.som.yale.edu/
peterschott/. These data span the period 1989–2005 and include only manufacturing industries. Following Fresard (2010) and Valta
(2012), we calculate the industry-year ad valorem tariff rate as duties collected at U.S. customs divided by Free-on-Board custom
value of imports. We compare tariff reductions in a given industry-year to the industry's median change over the period of 1990–2005
(since data starts in 1989, change in tariff calculations start in 1990). We define a significant tariff reduction for a specific industry-
year as one in which the negative change in the tariff rate is three times larger than the industry median change.17 To ensure that
tariff cuts truly reflect non-transitory changes in the competitive environment, we exclude tariff cuts that are followed by equiva-
lently large tariff rate increases. Further, we require industries with large tariff rate cuts to have three years of data before and after
the rate reduction. Using these filters, we identify 83 large tariff rate reductions between 1990 and 2005 (see Fig. 1): 31 of the 83
tariff cuts (37%) occur in 1995, which coincides with the creation of North American Free Trade Agreement (NAFTA).
Over the period 1990–2005, tariff rates tend to decrease for all industries. However, the rate of change for industries that do not
experience large reductions is much slower compared to that for industries that experience large reductions in tariff rates.
Specifically, Fig. 2 shows the average tariff rate for industries that do not experience large tariff rate reductions decreases from 3.3%
in 1990 to 2.0% in 2005 (0.08% decrease per year, on average). In contrast, Fig. 3 shows the average tariff rate for industries that
experience large tariff rate reductions decreases from 2.9% one year prior to the tariff cut to 1.6% afterwards (0.66% decrease per
year, on average).
Table 6 reports average values of industry concentration variables for industries that experience large tariff rate cuts over the two years
before and after the year of the tariff rate reduction (−2,+2). Time trends show an increase in productivity gap among industry firms
(AVE_PGAP increases from 0.2212 to 0.2827 and COV_EFF increases from 0.2424 to 0.3006 over the 5-year period around the tariff rate
reduction, both changes are significantly different from zero at 1%). Lower import tariff rates facilitate the entrance of foreign rivals. As
new firms enter, industries become more asymmetric (i.e., leader-laggard) with higher productivity gap among industry firms. We also see
that industries change from competing in strategic complements to competing in strategic substitutes (CSM decreases from 0.0605 to
−0.0462, significant at 1%). Finally, we see a decrease in industry concentration (HHI decreases from 0.1414 to 0.1270, FFR decreases
from 0.5787 to 0.5431, and CFFR decreases from 0.3565 to 0.1577, all significant at 1%). The decreases suggest that reductions in import
tariff rates influence the intensity of competition for domestic firms. This finding is consistent with findings in Valta (2012) and Bernard
et al. (2006) that lower import tariff rates facilitate the entrance of foreign rivals resulting in higher import penetration.
To investigate the effect of large reductions in import tariff rates on innovation intensity in a multivariate setting, similar to
Fresard and Valta (2016) and Valta (2012), we estimate the following regression model:
Innovationi, j, t = 0 + 1 Post Reductionj, t + Controls i, t+ i + uj + vt + i , j, t . (3)
As in the Eq. (2), i, j and t denote firm, industry, and year, respectively. Post Reductionj,t is a dummy variable equal to one if
industry j has experienced a tariff rate reduction in year t and zero otherwise. The coefficient on Post Reduction, β1, is the change in
innovation intensity for firms in industries that experience a competitive shock relative to the change for firms in industries that do
17
Following Valta (2012), if an industry experiences more than one tariff rate reduction larger than three times the median rate reduction in that
industry, we identify the largest tariff rate reduction as the event. In our sample, there are 40 manufacturing industries that never experience a large
tariff rate reduction. These industries serve as “control” industries.
56
Table 7
Quasi-natural experiment: large reductions in import tariffs.
This table reports regressions results of innovation intensity on industry concentration for 1989–2005 using a subsample that consists of man-
ufacturing industries (SIC codes 2000–3999) with import tariff data available. Tariff data is downloaded from http://terpconnect.umd.edu/
~lfresard/. The dependent variable is ln(R&D to Total Assets) in Panel A and ln(CW_Patents) in Panel B. Neck-and-neck (leader-laggard) industries
are those with below (above) median COV_EFF. Strategic substitutes (strategic complements) industries are those with CSM < 0 (> 0). Post
Reductionj,t is a dummy variable equal to one if industry j has experienced a tariff rate reduction in year t and zero otherwise. Estimation (1) includes
the full sample, (2) and (3) report results for neck-and-neck and leader-laggard industries, respectfully, and (4) and (5) report results for strategic
substitutes and strategic complements, respectfully. All regressions include firm, industry, and year fixed effects. Standard errors adjusted for within-
firm clustering are listed in parentheses. Significance at 5% and 1% is indicated by ** and ***, respectively.
(1) (2) (3) (4) (5)
Panel A: Dependent variable is R&D to total assets

Post reduction −0.003** −0.001 −0.012*** −0.001 0.004**
(0.00) (0.00) (0.00) (0.00) (0.00)
Constant 0.151*** 0.127*** 0.162*** 0.139*** 0.212***
(0.02) (0.01) (0.01) (0.02) (0.03)
Adjusted R2 0.30 0.19 0.35 0.30 0.27
No. observations 25,697 13,230 12,467 16,142 9555
Panel B: Dependent variable is CW_Patents

Post reduction 0.087** 0.092** −0.006 0.122** 0.026
(0.04) (0.05) (0.07) (0.05) (0.05)
Constant −0.480 0.040 0.660*** −0.155 0.245
(0.70) (0.33) (0.25) (0.54) (0.50)
Adjusted R2 0.09 0.10 0.07 0.08 0.11
No. observations 14,636 7535 7101 9226 5410
not experience a competitive shock.18 Control variables are the same as in Eq. (2).
Table 7 presents the results. The dependent variable in Panel A is ln(R&D to Total Assets) and in Panel B is ln(CW_Patents). The two
panels tell slightly different stories. Results indicate that a large reduction in import tariff rates has a significant negative effect on
innovation in the form of R&D (in Panel A, regression 1, the coefficient on Post Reduction is −0.003, significant at 5%), but a positive
effect in the form of patent activity (coefficient is 0.087 in Panel B, significant at 5%).
Looking at subsamples based on product market competition (regressions 2 and 3), consistent with Aghion et al. (2005) neck-and-
neck firms respond to threats by foreign rivals by increasing innovation in the form of patent activity (coefficient on Post Reduction in
regression 2, Panel B is 0.092, significant at 5%), but not through R&D (coefficient on Post Reduction in regression 2, Panel A is
insignificant). In contrast, leader-laggard firms respond to threats by foreign rivals by decreasing innovation in the form of R&D
(coefficient on Post Reduction in regression 3, Panel A is −0.012, significant at 1%). From Table 6, lower import tariff rates facilitate
the entrance of foreign rivals, which leads to industries becoming more asymmetric (i.e., leader-laggard) with higher productivity gap
among industry firms. Consistent with results from Panel C in Tables 4 and 5, as industries gravitate towards leader-laggard product
markets, innovation intensity decreases.
Finally, looking at subsamples based on degree of strategic interaction (regressions 4 and 5), firms competing in strategic sub-
stitutes respond to threats by foreign rivals by increasing innovation in the form of patent activity (coefficient on Post Reduction in
regression 4, Panel B is 0.122, significant at 5%), but not through R&D (coefficient on Post Reduction in regression 4, Panel A is
insignificant). From Table 6, after reductions in import tariff rates, industries change from competing as strategic complements to
competing in strategic substitutes. Incumbents competing in strategic substitutes make a commitment to deter entry (i.e., “top dog”
strategy) and increase their investments in innovation. In contrast, incumbents competing in strategic complements respond to
threats by foreign rivals by increasing their investment innovation in the form of R&D (coefficient on Post Reduction in regression 5,
Panel A is 0.004, significant at 5%).
18
This specification is like a difference-in-difference (DiD) approach. The important distinction between DiD and regression Eq. (3) is that this
specification accounts for the fact that competitive shocks are distributed over time. As such, the control group is not restricted to industries that
never experience a competitive shock. Rather, the control group is all firms from industries not experiencing a competitive shock at time t, even if
they have already experienced a shock or will experience one in later years.
57
5. Conclusion
In this paper, we present new evidence that there is a U-shaped relation between industry concentration and innovation (mea-
sured using R&D intensity and citation-weighted patents) for a large set of U.S. firms. Subsample results find that the overall U-shaped
relation is driven by neck-and-neck industries (industries operating closer to the efficient frontier). The results suggest that for these
equally productive firms, when industry concentration is low (the industry has many competitors), innovation intensity decreases as
concentration increases. However, at some point increased industry concentration (fewer competitors, operating at similar levels of
productivity) causes industry firms to increase innovation intensity. Increased concentration increases the incentive to invest in
innovation activities as a way to escape competition among fewer, but equally performing firms.
We also evaluate the degree of strategic interaction in industries by creating subsamples where industry firms compete in strategic
substitutes and strategic complements. In industries where firms compete in strategic complements, competitors match a firm's
strategic move and thus escalate competition. With strategic substitutes, competitors accommodate a firm's strategic move and thus
act complaisantly (a “less aggressive” strategy). We find that the U-shaped relation between industry concentration and innovation is
driven by industries where firms compete in strategic substitutes. When firms compete in strategic substitutes, competitors accom-
modate a firm's strategic move or even move in the opposite direction. Thus, the U-shaped relation between product market com-
petition and innovation is accentuated. When firms compete in strategic complements, competitors match a competitor's strategic
move, and thus escalate competition. In this case, increased investment may be a strategic handicap, because it may reduce the
incentive to respond aggressively to competitors.
Conflict of interest
Each author confirms that there is no conflict of interest.
Acknowledgements
The authors are grateful to Atul Gupta, Dirk Hackbarth, Saeid Hoseinzade, Alan Marcus, Mahdi Mohseni, Jim Musumeci, Gordon
Phillips, Kartik Raman, Husayn Shahrur, Ajay Subramanian, Anand Venkateswaran, and seminar participants at the Annual Meetings
of the Financial Management Association, Bentley University, Boston College, and Suffolk University for their helpful comments.
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Global Finance Journal 41 (2019) 44–59

Contents lists available at ScienceDirect

Global Finance Journal

Competitive environment and innovation intensity

ARTICLE INFO ABSTRACT

2. Related literature and testable hypotheses

3.2. Measures of innovation intensity

3.3. Measures of the competitive environment

3.3.1. Measures of industry level productivity gap

3.3.2. Measures of the degree of strategic interaction

3.3.3. Industry concentration

4.1. Descriptive statistics

Panel A – firm-level variables

Panel B – industry-level variables

Neck-and-neck (COV_EFF) 0.0398 24.2705 0.8569

ln(R&D to total assets) 1.0000

ln(CW_Patents) 0.0882 1.0000

4.2. Regression analysis

All Neck-and-neck Leader-laggard Strategic substitutes Strategic complements

Panel A: Regressions of R&D/total assets on HHI

Panel B: Regressions of R&D/total assets on FFR

Panel C: Regressions of R&D/total assets on CFFR

All Neck-and-neck Leader-laggard Strategic substitutes Strategic complements

Panel A: Regressions of CW_Patents on HHI

Panel B: Regressions of CW_Patents on FFR

Panel C: Regressions of CW_Patents on CFFR

Fig. 1. Distribution of tariff rate reductions between 1990 and 2005.

−2 0.2212 0.2424 0.0605 0.1414 0.5787 0.3565

4.3. Quasi-natural experiment: reductions of import tariffs

All Neck-and-neck Leader-laggard Strategic substitutes Strategic complements

Panel A: Dependent variable is R&D to total assets

Panel B: Dependent variable is CW_Patents

Each author confirms that there is no conflict of interest.

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