Does Competition Enhance or Hinder Innovation? Evidence from Philippine Small and Medium-Sized Enterprises.

• Author: Canare, Tristan

1. Background and Objectives

   Small and medium-sized enterprises (SMEs) form an important part of the economies of most developing countries. In Southeast Asia, SMEs comprise between 89 and 99 per cent of businesses, employing between 52 and 97 per cent of workers (ERIA 2014). In the Philippines, more than 99 per cent of all firms, about two-thirds of employment, and a third of gross value-added (GVA) are accounted for by micro, small or medium-sized firms (Dano-Luna, Canare, and Francisco 2018). The large difference between the SME share of total employment and the SME share of GVA suggests that, in the Philippines, labour productivity is far greater for large firms, putting SMEs at a disadvantage.

   The challenges faced by SMEs typically discussed in the literature include limited access to finance (Berger and Udell 1998; Beck and Demirguc-Kunt 2006), limited access to technology (Thong and Yap 1995; Lee and Runge 2001), limited access to markets (Rogerson 2013; Abor and Quartey 2010) and excessive regulations (Klapper, Laeven, and Rajan 2006; World Bank and IFC 2012, 2013). Studies have shown these factors to have significant negative impact on SME growth and performance.

   Another significant challenge faced by SMEs is limited innovation (Vossen 1998; Tabas, Beranova, and Vavrina 2011). Several studies have shown that innovation is linked to positive firm outcomes such as increased productivity (Hall, Lotti, and Mairesse 2008; Parisi, Schiantarelli, and Sembenelli 2006) and improved financial performance (Bigliardi 2012; Dunk 2011). Innovation is also important because it increases firm competitiveness (Porter 1992; McGrath et al. 1996). This is particularly noteworthy because competition can reduce a firm's market share, revenues and profit levels.

   Competition itself is another significant factor that may affect SME performance and growth. However, unlike other factors, studies on the impact of competition on SMEs have shown varied results. Covin and Slevin (1989) found that firms in highly competitive and hostile environments seek to innovate to protect themselves from and win against their rivals. Similarly, Aghion et al. (2009) and Okada (2005) found a positive relationship between competition and innovation; but Acs and Audretsch (1987) and Lunn (1986) found evidence to the contrary.

   The potential effect of competition on firm growth can be complex; and competition's potential impact on innovation can be at the centre of this. Competition has two possible contrasting effects on firm innovation and growth. On one hand, competition is seen as a deterrent to innovation. Competition can induce lower profits, which in turn provides a disincentive to innovate. One of the earliest proponents of this idea was Schumpeter (1942), whose theory was formally modelled by Aghion and Howitt (1992). On the other hand, competition can force SMEs to become more competitive by innovating (Porter 1990: Aghion, Dewatripont, and Rey 1999).

   The primary objective of this paper is to study the relationship between competition and innovation using a survey of SMEs in two regions in the Philippines. A secondary objective is to determine if this relationship varies across firm size (small versus medium) and across sectors (manufacturing versus services). The focus on SMEs is motivated by studies that have shown that small and medium firms innovate differently and could face different barriers to innovation compared to large businesses (Spithoven, Vanhaverbeke, and Roijakkers 2013; McAdam McConvery, and Armstrong 2004; Vossen 1998; Tabas, Beranova, and Vavrina 2011). Moreover, it has been shown that SMEs are less likely to survive in highly competitive environments (Mengistae 2006). These are significant observations because SMEs account for a large share of firms, production and employment in many developing countries.

   The use of Philippine data attempts to address the dearth of empirical competition-innovation literature using a developing country setting with data coming from a random survey of small firms. At present, most studies on this topic are either theoretical or focused on industrialized countries. Another contribution to the literature is the use of perception-based competition indicators, which are rarely used in empirical research. As will be discussed later, perception-based competition measures have certain advantages over those using objective industrial data.

   This paper is organized as follows. The background and objectives are followed by the framework and a brief review of literature on competition and innovation. Then comes the methodology, in which the data source and estimation method are discussed; followed by the results and discussions. A short summary concludes the paper.

2. Framework and Literature Review

   2.1 Innovation-Competition Theories

   There are two main contrasting themes in the theoretical literature on how competition can affect innovation. The first, espoused originally in the classic writings of Schumpeter (1942), is that competition deters innovation. The Schumpeterian argument has two primary transmission mechanisms from weak competition to innovation (Cohen and Levin 1989; Ahn 2002). First, the expectation of a firm that it will have some degree of market power is an incentive to innovate. In this view, market power is a reward of innovation; and a firm will only innovate if it has a reasonable expectation of attaining market power through this innovation. Similarly, a firm with market power has the incentive to innovate to keep that market power and prevent competitors from entering the market (Gilbert 2007). The second mechanism is that the rent generated from market power provides the financial resources needed to undertake innovation. Related to this, the model of "creative destruction" by Aghion and Howitt (1992) argues that, if there are more firms (and more competition), the prospect of more innovation in the future deters current innovation because greater future innovation threatens to reduce the rent created by present innovation.

   In contrast to the Schumpeterian view, some models argue that greater competition can promote innovation; primarily because competition forces firms to innovate in order to be more competitive and to survive tough competition (Aghion et al. 1999; Porter 1990). Ahn (2002) and Aghion and Howitt (1996, 1998) also discussed other similar ways by which competition can positively influence innovation. One case is when technologies of competing firms are similar. Under this condition, intense competition provides incentive to gain or maintain leadership in the level of technology. Another is when there is mobility of labour across production lines. When two competing firms employ different technologies or production lines--one using old technology and the other using new technology--workers will move to the newer and more productive production line because greater productivity usually implies higher wages. This provides the competing firms incentive to innovate (Aghion and Howitt 1996).

   Motta (2004) developed a simplified model that explains why a firm is more likely to innovate if it has more competitors. Two firms, a monopolist and one under a perfectly competitive market, incur marginal cost [C.sub.0] in producing their products. The monopolist charges a price greater than [C.sub.0] and earns a positive profit equal to [[pi].sub.0]. The perfectly competitive firm charges price equal to [c.sub.0] and earns zero profit. An innovation with the cost I will allow the firms to reduce their marginal cost from [c.sub.0] to [c.sub.1]. The reduction in cost will give the perfectly competitive firm advantage over its competitors, and it will increase its profit from zero to [[pi].sub.1]. On the other hand, the cost reduction will allow the monopolist to increase its profit from [[pi].sub.0] to [[pi].sub.1]. Therefore, the monopolist will only innovate if [[pi].sub.1]- [[pi].sub.0] > I, while the perfectly competitive firm will innovate if [[pi].sub.1] > I. The perfectly competitive firm will therefore have a greater incentive to innovate because the incremental increase in profit from the innovation is higher.

   More recent competition-innovation models studied aspects of competition beyond the competitive pressure exerted by rival firms. For instance, Acemoglu and Akcigit's (2012) model analysed the effect of the degree of intellectual property rights (IPR) protection on innovation in an industry where followers can copy the leaders. Their key result was that full IPR protection is not socially optimal. The optimal condition is stronger patent protection for innovators who are way ahead of their followers and weaker protection for those closer to their followers. In Lyandres and Palazzo's (2016) model, an innovative firm's cash holding is used for innovation activities. The model predicted that there is positive relationship between competition and cash holdings (and therefore innovation), and the relationship is stronger when the firm is financially constrained.

   2.2 Related Empirical Literature

   There is a rich body of literature that empirically tested these models using different methods and data sources. Gilbert (2006), Schmutzler (2009), Boldrin et al. (2011), and Ahn (2002) are some of the more recent reviews of empirical literature on the competition-innovation relationship.

   Most of the empirical literature support the theory that competition and innovation are positively related (Aghion et al. 2009; Okada 2005; Carlin, Schaffer, and Seabright 2004; Galdon-Sanchez and Schmitz 2002; Blundell Griffith, and Van Reenen 1999; Nickell 1996; Baily and Gersbach 1995; Acs and Audretsch 1988). Only a handful of studies support the Schumpeterian view, and most of these are not recent (Acs and Audretsch 1987; Lunn 1986; Lunn and Martin 1986; Culbertson and Mueller 1985). A few studies found no evidence of a significant relationship (Geroski 1990; Levin, Cohen, and...