Goods market competition is a double edged sword. The static welfare gains from increased competition come hand in hand with potentially negative effects on the dynamic incentives to innovate. This paper argues, however, that there is also a dynamic reason to support competition. The argument is based on the insight that many goods and services are widely used as intermediate inputs in other sectors. In the context of
development, we embed a simplified intermediate goods market structure in a model of technological diffusion, where innovators in lagging Southern economies instantly benefit from the technological knowledge of rich Northern economies, which creates a strong convergence force. We show that insufficient competition in local intermediate goods markets of developing countries may imply input price inflation, reducing
the profits to innovators and thus diminishing the returns to imitation of Northern technologies. In this respect, goods market competition plays a key role in providing incentives for innovative entrepreneurs in developing economies. A benchmark calibration exercise delivers productivity differences of more than 30 percent between distorted and undistorted economies on the balanced growth path. Preliminary empirical evidence
supports our model, showing that countries with stricter entry regulations exhibit higher appreciation rates of relative intermediate goods prices, not just higher levels of intermediate good prices.