This paper provides empirical evidence on the relationship between market competitive pressure and firms’ innovation using panel data of Spanish manufacturing firms for the period 1990-2006. We depart from standard summary measures of market competition, and construct variables to proxy for the fundamental determinants of competitive pressure (product substitutability, market size and entry costs) to test the main theoretical predictions of Vives (2008, Journal of Industrial Economics) for a free entry context. Our results line up favourably with the theoretical predictions. In particular, we obtain that greater product substitutability and higher costs of entry, in general, lead to more process innovation but less product innovation by firms. Furthermore, market enlargement seems to spur both product and process innovation. These results highlight the importance of taking into account different competitive pressure fundamentals for uncovering their different and even opposite effects on firms’ incentives for product and process innovation. These findings also suggest that the use of alternative indicators of firms’ innovation, such as total R&D or patents, may not capture these differential effects of competitive pressure fundamentals on product and process innovation. Our main results are robust across model specifications and alternative measurement of the key variables.