# 6.2 Product Market Competition and Entry Regulation

It is possible that financial development is correlated with other country characteristics which affect innovation by firms. Potential candidates include the supply of scientists, the quality of intellectual property rights institutions, or the general contractual environment. However, unless the effect of such characteristics on innovation differs systematically by firm size, they should not matter to the interpretation of the coefficient on the interaction of firm size with financial development. The wages of scientists and engineers, for instance, vary across countries but are unlikely to vary across firms within the same country and industry.

There is, however, a concern that the interaction term picks up the effect of crosscountry variation in the product market competition faced by large firms. This concern arises because of two factors. One, standard IO theory predicts that since competition reduces the monopoly rents that reward successful innovators, innovation should decline with competition.<sup>25</sup> Two, the extent of competition might be related to entry regulation, which is negatively correlated with financial development. This is evident in Table 3, which shows that two cross-country measures of entry regulation, the Doing Business<sup>26</sup> estimates of the time to start a new business (StartTime) and the cost of procedures to start a new business (StartCost) are negatively correlated with PvtCredit. There is also evidence, shown in Table 11, to suggest that larger firms face more competition when entry barriers are lower.

The outcome variable in the regressions shown in Table 11 is a firm-reported measure of the number of its domestic product market competitors. In column (1), this measure of competition faced by a firm is regressed on StartTime. There is no significant correlation between the two, but in column (2), where the explanatory variables include Size and Size*StartTime, the coefficient on Size*StartTime is negative, indicating that larger firms face relatively less competitors as entry barriers rise. This correlation is robust to using StartCost to measure entry regulations. The coefficients are statistically insignificant, perhaps because the firm-reported measure of competition is available for only 15 countries. However, this negative correlation between entry regulation and competition faced by large firms relative to small firms suggests controlling for the differential effect of entry regulation on innovation.<sup>27</sup> Table 12 presents probit estimates of the probability of R&D when interactions of entry regulations (StartTime or StartCost) with firm size are added to equations 2 and 3 as controls. Irrespective of which procedural measure I interact with firm size, the coefficient on Size*PvtCredit in Table 12 is close to that in the preferred specification which was reported in column (3) of Table 6. Thus, the association between relative R&D by small firms and financial development is robust to controlling for entry barriers.

> 25However, empirical work such Geroski (1995) , Nickell (1996) and Griffith et al. (1999) has pointed to a positive correlation between product market competition and innovative output. Aghion et al. (2002) develop a model in which competition and innovation have a U-shaped relationship.

> 26See www.doingbusiness.org for details; these measures were first developed in Djankov et al. (2002).

> 27Note that since competition is endogenous to innovation, it should not be included as an explanatory variable in itself.

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