Sunday, March 25, 2012
Competition and change (innovation): the inverted U relationship
We have been arguing that innovation ("profitable change") is the economic result of competition in the market. Innovation is a consequence, not a driver. The drivers are competition, survival and profiting. And the "innovation machine" that drives the capitalist model is based on the concepts of free market, including rule of law.
There are relationships between competition and innovation - but they are non linear and not straightforward.
Too little competition and incentives for innovation are low, stiffing economic change and growth. Monopolies may like it, but society does not. "Anti trust" laws in USA find here their origin and justification. Competition avoidance or exclusion have a negative social value and competition policy should help society to avoid them. Soviet Union collapse is usually related with lack of innovation, consequence of lack of competition and too much protected (non competitive) state enterprises under central planning.
But too much competition may be also harmful. An inverted U relationship between competition and innovation has been recognized. Too much competition can have adverse effects in innovation: if substitution of existing products (process) by new products (process) is too fast, economic depreciation may be insufficient, and it is impossible to restore the initial investment capital. Too much competition can be a negative incentive for innovators because opportunities to profit (at the individual and social level) mat be too weak to justify a sufficient incentive to the risk of innovation . An highly competitive market also tends to be too much fragmented and volatile: small companies have less resources to invest in innovation risks, and a small companies economy (like Portugal) can not afford the full needs of high intensity innovation activities.
We may argue that China case during last thirty years may suggest that "jungle" competition (intense competition within a market without a strong safety net based on rule of law) seems to have had a dramatic impact in economic growth, under the existing conditions: China may be a unique case in the history of development economics - decades of continuous high growth rate (often in the two digits range - see figure fir annual growth rate of China and USA from 1970). Until one day - nobody knows when and how. Soft or hard landing?. This is one question I have been following for last ten or fifteen years. (See here for a good update by Harvard professor Jeffrey Frankel). Advanced, or mature, economies have a common policy: to control and to limit "jungle" competition through legal regulation of the markets (rule of law, at the institutional and property levels.
The balance between "too little" versus "too much" competition policies seems to be a very tricky one. It seems to be path dependent and also dependent on the stage of development of each case.
William Baumol made a strong case for innovation as a engine of capitalism economic growth. But the social value of innovation may be difficult to evaluate against the individual value of innovation (for the innovator). The social value of competition, through change of process and products (innovation), may create difficult problems in competition policy.