The Effects of Entry on Incumbent Innovation and Productivity
GAICIL Insights
The same newcomer can make one incumbent sprint and another give up.1 The Effects of Entry on Incumbent Innovation and Productivity, by Philippe Aghion, Richard Blundell, Rachel Griffith, Peter Howitt and Susanne Prantl, shows the difference depends on how close incumbents are to the technological frontier. Using rich micro panel data for the United Kingdom, the authors find incumbent productivity growth and patenting positively correlated with lagged greenfield foreign firm entry in technologically advanced industries, and not in laggard industries.
These correlations reflect a causal effect predicted by growth theory built on creative destruction. A higher threat from technologically advanced entrants encourages incumbent innovation in sectors initially close to the frontier, the escape-entry effect. It may discourage incumbent innovation in sectors further behind, the discouragement effect of entry. Threat is a tonic for the strong and a sedative for the weak.
The intuition is clean. Incumbents near the frontier know they can escape entry by innovating, so a higher entry threat brings more intensive innovation aimed at escaping it. Incumbents far behind have little hope against an advanced entrant, and the threat shrinks their expected rents from innovating. The same competitive pressure spurs some firms and discourages others.
Identification is careful. The authors control for entry's endogeneity by exploiting major European and UK policy reforms and allow for endogeneity of other factors. Two independent data sources are used: establishment-level data on total factor productivity growth and patenting by stock-market-listed firms. Evidence on domestic entry and entry through imports complements the foreign entry analysis.
The parallel with today's technology is close. Artificial intelligence markets are full of advanced entrants, from startups to large firms expanding into new areas. Such entry spurs innovation by incumbents near the frontier, who innovate to stay ahead. Incumbents far behind may be discouraged, potentially exiting or ceasing to innovate. Every sector AI touches will split into sprinters and quitters.
The escape-entry effect helps explain AI's pace. When leading firms face credible threats from advanced entrants, they invest heavily to stay ahead. Openness to entry, including by foreign firms, can accelerate innovation among frontier incumbents. Keeping AI markets open to entry supports this dynamic. Fear of the newcomer is one of the industry's best accelerants.
The discouragement effect is the policy challenge. As AI lets advanced entrants challenge incumbents across the economy, firms far from the frontier may struggle. Helping lagging firms move closer to the frontier, through technology adoption, skills and finance, could turn discouragement into escape-entry responses. Close the gap, and the same threat becomes motivating.
Variation across industries argues for tailored policy. A uniform approach to entry and competition may have different effects across sectors. Policymakers should consider incumbents' technological position when assessing the likely effects of opening markets to AI-enabled entrants. A reform that energizes one industry may hollow out another.
Policy reforms as identification strengthen the evidence. The European single market and UK reforms provide entry variation plausibly independent of incumbents' innovation, enabling credible inference valuable for competition and trade policy in the AI era.
For competition policy, entry is a powerful spur to innovation where incumbents can respond. Protecting incumbents from entry may reduce innovation in frontier sectors. Encouraging entry while supporting lagging firms' upgrading can maximize innovation across the economy. Shelter from entrants is no gift to a capable incumbent.
The thread running through it all: entry spurs innovation by incumbents near the frontier and may discourage those far behind. As AI enables new waves of technologically advanced entry, its effects on incumbents will depend on their distance from the frontier. This study offers rigorous evidence for that heterogeneity and a framework for harnessing entry to drive innovation.
A hard question for industrial policymakers: pair every opening to AI-enabled competition with an upgrading program for laggards. Done together, entry becomes a spur across the economy; done alone, it may leave the weakest sectors discouraged.
Introduction
How does firm entry affect innovation incentives in incumbent firms? Microdata suggest that there is heterogeneity across industries. Specifically, incumbent productivity growth and patenting is positively correlated with lagged greenfield foreign firm entry in technologically advanced industries, but not in laggard industries. In this paper we provide evidence that these correlations arise from a causal effect predicted by Schumpeterian growth theory—the threat of technologically advanced entry spurs innovation incentives in sectors close to the technology frontier, where successful innovation allows incumbents to survive the threat, but discourages innovation in laggard sectors, where the threat reduces incumbents' expected rents from innovating. We find that the empirical patterns hold using rich micro panel data for the United Kingdom. We control for the endogeneity of entry by exploiting major European and U.K. policy reforms, and allow for endogeneity of additional factors. We complement the analysis for foreign entry with evidence for domestic entry and entry through imports.
Takeaway
In this paper we investigate the substantial heterogeneity we see in the effects of entry on incumbent performance. We show first that the finding can be explained in the context of a simple multi-sector Schumpeterian growth model with entry. The main implication of the theoretical model is that a higher threat from technologically advanced entrants should encourage incumbent innovation in sectors that are initially close to the technological frontier (this we refer to as the “escape-entry effect”), whereas it may discourage incumbent innovation in sectors that are initially further behind the frontier (this we call the “discouragement effect” of entry). The intuition for these two effects is quite simple. In the former case, incumbent firms that are initially close to the frontier know they can escape entry by innovating; therefore a higher threat of entry will result in more intensive innovation activities aimed at escaping that threat. In the latter case, incumbents that are further behind the frontier have no hope to win against an entrant. In the second part of the paper, we estimate the effects of entry allowing for effect heterogeneity. We use panel data from two entirely different sources - one containing information on incumbent TFP growth at the establishment level, the other containing information on patenting behavior of stock market listed firms.1
Notes
- Philippe Aghion et al., The Effects of Entry on Incumbent Innovation and Productivity, 91 Rev. Econ. & Stat. 20 (2009), https://doi.org/10.1162/rest.91.1.20. Takeaway source: Conclusions, reproduced from a free author or repository copy (working-paper version). ↩
Cite as: Philippe Aghion et al., The Effects of Entry on Incumbent Innovation and Productivity, 91 Rev. Econ. & Stat. 20 (2009), https://doi.org/10.1162/rest.91.1.20
Header image: Observatory Telescope at the University of Saskatchewan.jpg by SSPWXR, CC0, via Wikimedia Commons.
