Effect of agglomeration on firms’ research and development investment: a U‐shaped relationship

Extant research on how agglomeration affects firms’ R&D investment reveals conflicting views. Some studies suggest that, owing to free riding arising from knowledge spillovers, agglomeration reduces firms’ R&D investment, whereas others find that it creates additional incentives for innovation through intensifying local competition, thereby increasing firms’ R&D investment. Thus, this study attempts to reconcile these two conflicting views. We propose a U‐shaped relationship between agglomeration and firms’ R&D investment; that is, when the extent of agglomeration is low, knowledge spillover effects are important, while local competition is negligible. The free riding effects dominate local competition effects. Therefore, firms’ R&D investment decreases with the extent of agglomeration at a decreasing rate. By contrast, when the extent of agglomeration is high, local competition becomes the dominant force. Consequently, firms’ R&D investment increases with the extent of agglomeration at an increasing rate. Using data from 299,256 manufacturing firms in China, we find that firms’ R&D investment first decreases with the extent of agglomeration to reach a minimum, then increases as the extent of agglomeration continues to rise. These results indicate that there is a robust U‐shaped relationship between agglomeration and firms’ R&D investment.