Downstream Competition and Upstream Innovation: Theory and Evidence from China

Competition is the catalyst of corporate innovation, which is the foundation of a country’s core competitiveness. From the view of vertical industrial chain, this paper examines how downstream competition affects upstream firms’ innovation output. Given innovation helps reduce the production cost of each product, increasing demand of intermediate products caused by downstream competition enhances the marginal revenue of upstream firms’ innovation, thus leading to an innovation incentive effect. To identify causality, we utilize China’s WTO accession, a quasi-natural experiment, to calculate downstream competition combined with import tariff reduction and input-output table, and then run a difference-in-difference regression. Using the data of Annual Survey of Industrial Firms and State Intellectual Property Office, our results find that downstream competition has a significantly positive impact on upstream firms’ innovation, and this effect is more pronounced in firms with less industry competition, greater initial innovation capacity and weaker financial constraints. Moreover, the number of firms, the degree of industry competition and the scale of intermediate products in the downstream sector increase, confirming the market size channel. In sum, our findings document that downstream competition can motivate upstream firms to innovate through vertical industrial chain, providing some useful insights for China to build a fair market competition environment and promote innovation-driven growth regime.