The relationship between competition and innovation: measuring innovation and causality

Technological progress is an important engine of economic growth. The recognition of the importance of technological progress for firm performance and economic growth has ignited the search for drivers of innovation. The search for these drivers and the seminal work of Schumpeter (1942) raised the interest in the relationship between competition and innovation among policymakers and researchers. One of the most fundamental difficulties in the extant literature is the identification of an innovation. Innovations are especially difficult to measure in the service sector, where conventional innovation measures are not readily available. Another fundamental difficulty is to capture the causal effect of competition on innovation and vice versa. This thesis introduces a new measure of innovation based on technological gaps between firms to examine the effect of competition on innovation in the U.S. banking sector. The results show that there is an inverted-U relationship between competition and innovation. Furthermore, both the consolidation trend and deregulation reduced the degree of competition and the innovation incentives of banks. The findings in this thesis also show that the innovation behavior of large banks is relatively more responsive to changes in competition. This thesis also focuses on the effect of innovation on competition. In contrast to the extant literature, this thesis incorporates the effects of innovation input and output on competition in one framework. The findings show that while innovation input affects competition positively, innovation output reduces the degree of competition. It is important to distinguish these dimensions of innovation since innovation input and output are interrelated. The relationship between innovation inputs and output is examined in detail by investigating innovation production functions and the determinants of inefficiency. The results show that the innovation production functions exhibit decreasing returns to scale and that inefficiencies are present during the production of innovations.