When China's manufacturing boom began threatening American factories in the late 1990s, conventional wisdom suggested U.S. companies had two options: slash costs or close shop. But new research reveals a third path that many successful American manufacturers have taken - doubling down on innovation.

"The standard advice was that you couldn't compete with Chinese manufacturers on cost," says Adrien Matray from UC Berkeley, who recently co-authored a major study on the topic with Johan Hombert from HEC-Paris. "What we didn't know until now was just how effective innovation could be as a defensive strategy."

The transformation of the American furniture industry tells the story. While many U.S. furniture makers shuttered their factories in the face of Chinese competition, companies that invested heavily in research and development found ways to survive and even thrive. These companies didn't try to match Chinese prices - instead, they focused on creating unique products that commanded premium prices.

The numbers are striking. When Chinese imports surge into an industry, companies that don't invest much in R&D typically see their annual sales growth drop by about 2%. But companies that invest heavily in innovation experience only half that decline. More importantly, they manage to keep their workers employed and their factories running.

"It's not just about surviving," explains Matray. "These companies actually find ways to grow even when facing intense competition from China. They do this by making products that are different enough from their Chinese competitors that customers are willing to pay more for them."

The study's findings challenge a persistent myth in American manufacturing - that innovation is a luxury companies can't afford when facing tough competition. In fact, the opposite appears to be true. Companies that maintain their R&D spending during difficult times end up better positioned to weather the storm.

Take the example of American textile manufacturers. While many basic textile producers were forced out of business by Chinese competition, companies that invested in developing advanced fabrics for medical, military, and high-tech applications managed to carve out profitable niches that were largely protected from import competition.

But there's a catch. Innovation isn't cheap, and many companies cut their R&D budgets first when facing competitive pressure. This is where state governments have played a crucial role. Tax breaks for R&D spending, offered now in more than 32 states, have helped many companies maintain their innovation efforts even when facing tough competition.

"Think of it as a virtuous cycle," says Matray. "State tax breaks help companies invest in R&D, which helps them develop unique products, which in turn helps them stay profitable enough to keep investing in innovation."

The implications extend beyond individual companies to entire communities. When factories close, the impact ripples through local economies. But the research shows that innovative companies are much more likely to keep their workforce stable, helping maintain the economic health of their communities.

Looking ahead, the study suggests that the future of American manufacturing might depend less on competing with China on price and more on maintaining America's innovation edge. But this will require sustained commitment from both companies and policymakers to support R&D investment.

"The choice isn't between innovating and competing," concludes Matray. "Innovation is how you compete in today's global market. The companies that understand this are the ones that will still be around in twenty years."

For American manufacturers facing growing competition from abroad, the message is clear: the best defense might not be lower prices or higher walls, but better products born from sustained investment in innovation.

Adrien Matray is an economist specializing in applied macroeconomics and finance with a focus on misallocation, development, trade, and entrepreneurship. He has held positions at Ivy League and other top-tier institutions, including Harvard University, where he currently serves as a visiting assistant professor. Matray earned his Ph.D. in Finance from HEC Paris.

Johan Hombert is a Professor of Finance at HEC Paris, where he also serves as the Director of the Ph.D. Program. He graduated from École Polytechnique and holds a Ph.D. in Economics from the Toulouse School of Economics. Hombert's research interests include entrepreneurship and innovation, frictions in financial markets, and life insurance.