Using a dynamic model of a step-by-step innovation race between financially constrained firms, I study how financial constraints affect innovation activity. The novel theoretical results derive from an analysis of the interaction between the incentive effect of competition on inno- vation and the effect competition has on the degree of credit rationing. I find that the negative effect of financial constraints on firm- and aggregate-level R&D investment is most pronounced at both high and low levels of competition. These predictions are supported by empirical evidence: The competition-innovation relationship has an inverted-U shape in less financially developed systems relative to the benchmark pattern observed in countries with highly developed financial systems. Innovation-enhancing policies implemented through competition reforms ought to be complemented by promoting financial development.
