Competition and Investment: What do we know from the literature?

The link between competition and investment is one of the most important relationshipsexamined in economics. For more than two centuries economists have held conflicting viewsof which market structures create the most favorable environment for economic growth, whileacknowledging that it benefits from investment in both infrastructure and innovation.According to Adam Smith's fundamental lessons, competition guarantees that consumers'needs are best satisfied, minimizing the rents left to the firms. Economists of the Austrianschool have criticized this view and instead emphasized that even more important than thecompetition structure is the competitive process. An even more skeptical view was offered bySchumpeter who argued that concentrated market structures are optimal and monopoly rentsare a driving force that promotes economic growth.A parallel can be drawn between innovation and investment which then gives rise to twoconflicting effects of competition on investment. First, strong product market competitiondecreases profits and then lowers incentives to innovate. Second, competition may providefirms with incentives to innovate to escape from competition in the product market. This"escape competition" effect dominates when the ex-post market power is relatively high whilethe opposite holds when the market is more competitive. The two effects are embedded in theinverse U-shaped curve between competition and innovation developed by Aghion et al.(2005) so the optimal degree of competition is intermediate.A look at the investment in infrastructure also offers a contrasted view on the benefits ofcompetition. Alesina et al. (2005) studied the role that overall regulation, barriers to entry andpublic ownership play in investment for many nonmanufacturing industries (energy,transports, communication). They showed that competition-enhancing policies do promoteinvestment. But studies more focused on the (fixed-line) telecommunications sector havehighlighted a possible negative impact on network investment when market entry is promotedthrough local loop unbundling. Additionally, the impact of unbundling -- which can be seenas a competition-enhancing policy – on penetration rate is still under debate but seems to be atbest negligible.Therefore, the impact of competition on investment depends both on precise competitionenhancing measures and the type of investment at stake.