We develop a formal model to analyze the relationship between market competition and firm innovation. We start from the premise that increasing competition (1) lowers post-innovation profits and therefore discourages innovation, but (2) increases the threat of failure without innovation and therefore encourages innovation. We then incorporate both the profitability and survival to innovation in our model and allow for a general competitive market structure. We show that in a competitive market and when process innovation results in the creation of a new low cost facility, the return to innovation is more sensitive to competition than the return to investment and thus firms reduce innovation when competition increases. We test these predictions by examining US firms’ investment in unconventional-well technology between 2010 and 2018. Consistent with our model’s predictions, firms innovated less when competition increased, with high capability firms innovated even less than low capability firms.
