Globalization brings opportunities and pressures for domestic firms in emerging market economies to innovate and improve their competitive position. Using recent data on firms in 27 transition economies, we test for the effects of globalization through the impact of increased competition and foreign direct investment on domestic firms’ efforts to raise their capability (innovate) by upgrading their technology or their product/service (improving quality or developing a new one), taking into account firm heterogeneity. We find support for the prediction that competition has a negative effect on innovation, especially for firms further from the frontier, and that the supply chain of multinational enterprises and international trade are important channels for domestic firm innovation. We do not find support for the inverted U effect of competition on innovation. There is partial support for the hypothesis that firms in a more pro-business environment invest more in innovation and are more likely to display the inverted U relationship between competition and innovation.