Schumpeter’s Vindication: The Enduring Link Between Scale and Innovation

Over the past few years, antitrust populists have repeatedly argued that in markets, “big is bad.” Yet empirical research, including studies conducted by two newly announced Nobel Laureates, has consistently proven otherwise, particularly when it comes to innovation. A recently published paper reinforces this conclusion by analyzing 95 empirical studies and 655 statistical estimates of the effects of size on innovative performance drawn from the literature. Using “meta regression analysis”, the authors found an overall positive average effect of firm size on innovation in the econometric literature.

These findings should not be surprising, as influential economist Joseph Schumpeter was unequivocal that large firms are better positioned to increase output and promote economic growth over time by driving innovation. But why? In light of the empirical research and these new findings, it is worth revisiting Schumpeter’s main arguments about the relationship between firm size and innovation, as well as what modern evidence shows.

Schumpeter’s analysis suggests that firms with market power have both a greater incentive and ability to innovate. Regarding incentives, a principal Schumpeterian argument is that larger firms with market power have more to lose from disruptive innovation, giving them strong motivation to keep up with what Schumpeter called “creative destruction”—the rapid technological changes that leave entrepreneurs standing on ground “crumbling beneath their feet.” In other words, firms with market power that rest on their laurels risk being swept away by the perennial gales of creative destruction.

This is particularly true of industries characterized by dynamic competition, where incumbents earn high profits. As Robert Atkinson and Michael Lind explain in Big is Beautiful, “rather than being anti-consumer, these higher returns are a boon to consumers because most innovation companies have to reinvest these profits into the next round of risky innovation to stay alive.”

Critics of this view argue that larger firms with market power have a disincentive to innovate because doing so could cannibalize their own products and profits. In other words, such firms might avoid innovation because it eats into the sales of their existing offerings. This argument, however, overlooks the significant role of incremental innovation in driving economic growth. For instance, a recent empirical paper finds that most innovation comes from incumbent firms that improve their existing products. The authors provide evidence that most total factor productivity (TFP) growth from 1983 to 2013 resulted from this “own innovation” by incumbents rather than products from new entrants, which corroborates the Schumpeterian claim that firms with market power often drive economic growth through innovation.

A second incentive that Schumpeter identified is that powerful firms can reap large profits from successful innovation when they are able to appropriate the returns. That said, appropriability only exists when a firm is sufficiently insulated from imitators that might free ride on its investments and siphon off the social benefits of the innovation. According to this view, a company must have some market power to ensure that it can capture the gains of its innovative efforts.

A counterargument to this comes from a 1962 theoretical paper by economist Kenneth Arrow, who found that competitive firms may have a greater incentive to innovate due to the lure of supercompetitive profits. Arrow demonstrated that, under certain assumptions, competitive firms are more motivated to escape price competition and low profit levels by innovating, compared with monopolists who already earn economic profits. However, empirical research has shown that the relationship between market structure and innovation tends to follow a more Schumpeterian pattern: Innovation rises with market concentration up to a point, then declines. This dynamic, known as the “inverted U” relationship, suggests that smaller firms in fragmented markets innovate less than larger firms in oligopolistic ones, while innovation in oligopolies often exceeds that in pure monopolies.

Finally, Schumpeter claimed that large firms with market power also have a greater ability to innovate, thanks to greater scale, resources, and financial capacity to engage in high-risk R&D. While some antitrust economists, including Carl Shapiro, opine that modern capital markets diminish this advantage, it is implausible that financial markets alone can provide sufficient funding for innovation, especially in the contemporary context. Indeed, a new ITIF report documents that the R&D spending of American “big tech” firms exceeds the total R&D spending of many foreign nations, and includes hundreds of billions in projected AI investments over the coming years. Given the massive scale of investment and innovation amid the current gales of AI-driven creative destruction, it is unlikely that financial markets alone could provide the same level of optimal and sustained funding.

Large firms therefore have both the incentive and ability to invest in innovation—and, as new empirical research suggests, they generally do. This largely vindicates Schumpeter’s central arguments about market structure and innovation, which he himself based on real-world observation. To be sure, as many antitrust scholars argue, enforcers may still be concerned about innovation-limiting effects of market structure in certain contexts. But they should also recognize that scale promotes innovation rather than stifling it.

As antitrust economist Carl Shapiro notes, it is an “audacious” task “to distill lessons from the huge and complex literature on competition and innovation that are simple and robust enough to inform competition policy.” Nonetheless, the connection between firm size and innovation has proved remarkably enduring since Schumpeter’s influential work. And, as this year’s Nobel Prize in economics suggests, the benefits of scale for innovation and economic growth deserve renewed and ongoing attention in policy circles.