Price Wars and the Direction of Innovation

This paper examines the impact of price wars on the direction of innovation. We argue that dominant firms launching a price war may affect the direction of innovative effort of the higher cost rivals. While such competitive action may trigger exit and retard entry, it may also sway the investment choices of the a priori higher cost firms towards efficiency-enhancing innovations. We find support for the conventional hypothesis that a price war affects aggregate resource reallocation through an increase in exit and a decrease in entry. The novelty of the paper lies in our second hypothesis regarding the treatment effect of a price war, whereby surviving rivals increase their cost-reducing and efficiency-enhancing innovations. Using a dataset of U.S shale oil producers at the well level, we trace the different effects of the 2014 oil price war on resource reallocation and innovative effort. We find support for our hypothesis that price wars can also have the unintended effect of redirecting innovative efforts of weaker competitors such that the period after the price war is likely to result in a smaller set of stronger firms in the industry. This suggests an alternative pathway by which a competitive industry might evolve into an oligopoly.