How does competition affect incentives to innovate? The significant economic contributions made by innovative entrepreneurs strongly suggest that competition increases incentives to innovate. The discussion in this chapter explains why entrepreneurs generate more innovative projects than an incumbent monopoly with multiple projects. Additionally, competition between entrepreneurs and a monopoly incumbent with multiple projects generates more innovative projects than would the incumbent firm without competition.

At first glance, however, it might seem that competitive pressures would decrease entrepreneurial incentives to innovate. Creative destruction dissipates economic rents thereby reducing incentives to enter the market with new products, manufacturing processes, or transaction methods. Innovative entrepreneurs face many types of vigorous competition: from other entrepreneurs both present and future; from traditional and informal institutions; and from incumbent firms. Entrepreneurial entrants face the risk that the new firms will expand industry capacity above the level that is needed to serve the market. Then, entry will generate vigorous competition, leading to rapid exit or protracted shakeouts of new and existing firms. Entrepreneurial entrants face the risk of unsuccessful entry because other entrants or existing firms will offer better innovations. Entrepreneurial entrants also face the risk that their innovations will fail to perform well: new products may prove unpopular with customers, new manufacturing processes may not function efficiently, and new transaction methods may not be widely adopted. Finally, entrepreneurial entrants face the risk that their innovations will be imitated or expropriated by other entrants and incumbent firms.