however, that these arguments for open trade policies are not entirely unconditional. If development of a national industry creates localized knowledge spillovers, there may be a rationale for intervention. This was form of infant-industry argument was one of the justifications for import-substitution strategies in many developing countries in the 1950s and 1960s. Nevertheless, trade restrictions may not be the most effective way of fostering domestic R&D, industrial development or spillovers, since they create new distortions, reward domestic firms whether they innovate or not, and have a high cost, not least by restricting international knowledge inflows. More direct policies to subsidize domestic R&D, improve the investment climate and strengthen education are likely to prove superior.

_Competition_ . As with trade openness, the question whether greater competition in domestic product markets serves to foster innovation does not have an entirely simple answer. A survey of OECD countries by Ahn (2002) comes to the agnostic conclusion that “empirical evidence does not support the view that market concentration is an independent and significant determinant of innovative behavior and performance,” Although other studies (for example Nickell, 1996, and Blundell, Griffith and Van Reenen, 1999) have pointed to a positive correlation. Evidence is much thinner for developing economies, but Ayyagari et al (2006) also find a positive relation between several competition indicators and their broad measure of firm dynamism in low and middle income economies.

Aghion, Bloom, Blundell, Griffith and Howitt (2005) observe that greater product market competition between incumbent firms could have different effects that both discourage and promote innovation. In industries where the existing level of competition is low and firms have similar levels of technological capability, more competition may promote innovation by giving the innovating firm a competitive advantage. On the other hand, in industries where there is already high product market competition and one firm has a large technological lead over others, a further increase in competition may discourage innovation by lagging firms because it reduces the rewards for trying to ‘catch-up’. The study finds strong evidence for such an ‘inverted U curve’ in multi-industry panel data for UK firms. Aghion, Blundell, Griffith, Howitt and Prantl (2006) argue that entry of technologically advanced firms into an industry can also have a similar dual-edged effect on innovation, tending to stimulate innovation when incumbent firms are close to the global technology frontier, but discouraging it when they are technological laggards.

Given the limited empirical evidence, it is probably unwise to draw firm conclusions for policy in East Asian or other developing countries. But a few observations can be hazarded. First, increased competition has many potential benefits effort economic performance other than the impact on innovation, for example on firm efficiency and overall productivity growth. (Ahn, 2002). Conclusions about the role of competition policy need to be based on an assessment of all of these effects. Second, the balance of empirical work cited finds a positive association between more competition between incumbent firms and innovation. While the study by Aghion, Bloom, Blundell, Griffith and Howitt (2005) reaches more qualified results, it too suggests that more competition is favorable for innovation when competition is low to start with – that is, when lack of competition is most likely to be of concern to policymakers.

Turning to new firm entry, the interesting findings by Aghion, Blundell, Griffith, Howitt and Prantl (2006) for the U.K. obviously need to be buttressed by more empirical work across a wider range of countries (including developing countries). There are several hypotheses that need further empirical testing. One is that opening up to entry by technologically sophisticated competitors may be especially beneficial for innovation by incumbent firms in advanced 32