Big Firms Might Innovate More — Or Less in Face of Global Competition
In an increasingly interconnected economy, large multi-product firms are often at the mercy of international technological advances, especially those that enhance the competitiveness of foreign export
A critical question asked in a paper (Foreign Competition and Innovation by Elhanan Helpman) in such scenarios is: do these firms react to increased foreign competition by doubling down on innovation, or do they pull back?
The Productivity-Innovation Nexus
A glimpse into this dynamic reveals a nuanced landscape. Initial conditions suggest all multi-product firms reach an equilibrium. In this steady state, the breadth of their product offerings remains constant over time. This stability, however, is disrupted when foreign players alter the technology game.
The ripple effects of these changes are captured in a study by Helpman and Niswonger, which posits that firms' responses are only sometimes straightforward. Productivity levels within these firms play a pivotal role, and interestingly, the relationship between a firm's number of products and its productivity can sometimes exhibit an inverted U shape.
The Counterbalance: Innovation vs. Product Span
When technological advancements reduce costs for foreign exporters, this affects market dynamics by altering prices and, consequently, the marginal profits associated with a firm's range of products. This shift can lead to one of two reactions from a large firm: If the marginal profits of expanding their product range increase, the firm is likely to invest more in R&D, extending its product span. If these profits decrease, the firm might reduce its R&D investments, shrinking its product span.
The implications are profound for the innovation trajectories of firms. The pivotal factor determining whether a firm will expand or contract its R&D efforts, thus its product span, hinges on the marginal value of adding new products in response to international trade shocks.
Profitability vs. Innovation: A Delicate Balance
But there's a twist: short-term operating profits might only sometimes be reliable indicators of the long-term profitability of innovation. Even as immediate profits dip, the longer-term strategic play might lean towards bolstering innovation. On the flip side, a boost in short-term profits does not necessarily signal that cutting back on innovation is prudent.
Take, for example, a situation where foreign competition intensifies. Suppose this intensity drives down a firm's operating profits. Does this mean innovation is less profitable? Not necessarily. If expanding the firm's product line can mitigate the profit losses triggered by foreign competition, then innovation remains a valuable endeavor despite the immediate financial hit.
A Diverse Corporate Landscape
What unfolds on the macro scale reflects the productivity spread across firms within the economy. If the domestic market is dominated by lower-productivity firms, a surge in foreign competition might depress both short-term profits and innovation. But if higher-productivity firms dominate, they might continue to invest in innovation, potentially offsetting the negative impacts on operating profits.
In essence, the interplay between operating profits and the profitability of R&D is complex. It can vary significantly across firms with different productivity levels.
Conclusion: Looking Beyond the Short-Term
The crucial takeaway from the paper for industry leaders and policymakers is that the relationship between operating profits and the profitability of innovation must be boiled down to more than simple cause and effect. As the global market adjusts to technological shifts, the strategic moves of large firms will likely continue to oscillate between expanding and contracting R&D efforts, influenced by a myriad of factors beyond immediate financial outcomes.