Introduction

The Dixit and Stiglitz (1977) paper provides a tractable way to model competition between firms. This has been used in many areas in economics, such as international trade, industrial organisation and growth theory. This chapter focuses on an application in the intersection of industrial organisation and growth theory: what is the effect of competition on firms' incentives to innovate? In particular, what is the effect of competition on the form of innovation that the firm chooses?

The effect of competition on the amount of innovation by firms has been extensively analysed. Examples are Aghion and Howitt (1992), Aghion, Dewatripont and Rey (1997), Hermalin (1992), Martin (1993) and Schmidt (1997). Instead, this chapter considers the effect of competition on the form of innovation. In particular, I assume that firms can choose between two strategies: a defensive and an enterprising strategy. The ‘defensive’ strategy keeps a firm's costs low without affecting its competitive position or market share. The ‘enterprising’ strategy improves a firm's competitive position in the market. The question I want to address is: does a rise in competition make firms more or less enterprising? The two main applications I have in mind here are downsizing and the ‘Porter hypothesis’, which I discuss in turn.

In the 1980s and 1990s firms invested heavily in downsizing. Examples are National Westminster bank, AT&T,IBM and Scott Paper. In the management literature, downsizing is seen as a defensive strategy. Downsizing mainly cuts labour costs, without making firms more innovative.