THE WILLIAM DAVIDSON INSTITUTE AT THE UNIVERSITY OF MICHIGAN BUSINESS SCHOOL Competition, Innovation and Growth in Transition: Exploring the Interactions between Policies

Transition has entailed the introduction of policies to stimulate product market competition, to establish effective corporate governance and to harden enterprise budget constraints. How do these policies interact? Are they substitute policy instruments or does one policy reinforce the effect of another? Although early endogenous growth models predicted a negative relationship between competition and innovation, Aghion, Dewatripont and Rey (1999) showed that this could be reversed if agency considerations were introduced. In their model competition acts as an incentive mechanism to reduce managerial slack, which produces the additional prediction that competition and corporate governance are substitutable. But in a profit-maximizing framework in which incumbent firms innovate to escape competition, there will be complementarity between increased product market competition and governance and between competition and hard budget constraints (Aghion and Howitt 2002). We use the EBRD-World Bank Enterprise survey of over 3,000 firms in 25 transition countries to test for interaction effects between policies. We find that competition and hard budget constraints are complementary. We also find that competitive pressure (a) enhances the performance of old firms, which is suggestive of a role of agency effects and hence of policy substitutability and (b) enhances the performance of new firms, which is consistent with complementarity. Finally, the evidence points to the prevalence of financing constraints facing new firms. JEL codes: G32 , L10 , O31, P20 ∗We are grateful for comments on initial presentations of these results from participants in the EBRD’s Tenth Anniversary Conference, and from seminar participants at Brunel and Newcastle Universities. †Harvard University and University College London, CEPR and WDI ‡University College London, CEPR and WDI §Heriot Watt University, CEPR and WDI