Trade flows are complex. Protecting some domestic firms may have inadvertent impacts on others, write Pian Shu and Claudia Steinwende

Shu, Pian

Steinwender, Claudia

English

LSE Research Online

How free trade changes domestic firms’ ability to innovateLSE Research Online URL for this paper: http://eprints.lse.ac.uk/104619/Version: Published VersionOnline resource:Shu, Pian and Steinwender, Claudia (2020) How free trade changes domestic firms’ ability to innovate. LSE Business Review (29 Jan 2020). Blog Entry. lseresearchonline@lse.ac.ukhttps://eprints.lse.ac.uk/ ReuseItems deposited in LSE Research Online are protected by copyright, with all rights reserved unless indicated otherwise. They may be downloaded and/or printed for private study, or other acts as permitted by national copyright laws. The publisher or other rights holders may allow further reproduction and re-use of the full text version. This is indicated by the licence information on the LSE Research Online record for the item.How	free	trade	changes	domestic	firms’	ability	toinnovateInternational	trade	as	a	percentage	of	global	GDP	more	than	doubled	in	the	35	years	from	1973	to	2008;	but	tradeactivity	has	slowed	since	the	onset	of	the	Great	Recession.	Although	economists	have	long	argued	that	trade	iswelfare-enhancing,	there	is	increasing	scepticism	of	trade	and	globalisation	among	policymakers	and	the	generalpublic.	In	a	recent	paper,	we	survey	the	empirical	literature	on	how	trade	liberalisation	impacts	domestic	firms’incentives	and	abilities	to	innovate;	because	innovation	is	a	fundamental	driver	of	economic	growth,	this	question	iscentral	to	trade	policy.Figure	1.	Growth	of	international	trade,	1960-2016LSE Business Review: How free trade changes domestic firms’ ability to innovate Page 1 of 3		Date originally posted: 2020-01-29Permalink: https://blogs.lse.ac.uk/businessreview/2020/01/29/how-free-trade-changes-domestic-firms-ability-to-innovate/Blog homepage: https://blogs.lse.ac.uk/businessreview/Source:	World	Development	IndicatorsTrade	liberalisation	can	impact	a	given	firm	in	a	range	of	ways	in	both	the	output	markets	(where	the	firm	sells	itsproducts	and	services)	and	the	input	markets	(where	it	buys	intermediate	goods).	From	the	perspective	of	WidgetCorp.,	trade	liberalisation	could	bring	an	influx	of	foreign	competition	into	domestic	markets	and/or	provide	accessto	foreign	markets.	We	categorise	these	different	types	of	trade	shocks	using	a	2-by-2	matrix	in	Table	1.Table	1.	A	categorisation	of	trade	shocksImpact	of	import	competition	on	firm	innovationWhen	foreign	firms	enter	Widget	Corp.’s	domestic	output	market,	they	generate	import	competition,	which	has	anambiguous	impact	on	innovation	in	theory.	A	number	of	factors—such	as	the	potential	profits	the	firm	could	capturefrom	additional	innovation,	managerial	efficiency,	and	firm-specific	moving	costs—could	all	be	in	effect.	Empirically,there	is	strong	evidence	that	import	competition	spurs	productivity	and	innovation	for	firms	in	emerging	economiesand,	to	a	lesser	extent,	Europe;	but	the	evidence	is	more	negative	for	firms	in	the	U.S.	and	Canada.	We	proposethat	these	regional	differences	may	be	explained	by	differences	in	the	initial	levels	of	competitiveness	as	well	as	theextents	of	market	frictions	in	domestic	markets.	Within	a	country,	studies	typically	show	that	initially	more	productivefirms	tend	to	be	more	positively	(or	less	negatively)	impacted	by	import	competition.Impact	of	export	opportunities	on	firm	innovationExport	opportunities	provide	Widget	Corp	with	access	to	new	foreign	output	markets.	Unlike	import	competition,export	opportunities	are	generally	found	to	have	positive	effects	on	firm	productivity	and	innovation	regardless	ofthe	country	of	origin.	Export	opportunities	increase	the	returns	to	innovating	by	expanding	the	output	market	towhich	a	firm	has	access.	Furthermore,	they	could	induce	learning,	especially	for	exporting	firms	in	developingcountries	that	interact	with	more	technologically	advanced	foreign	counterparts.	As	with	import	competition,	theseproductivity	benefits	tend	to	accrue	disproportionately	to	firms	that	were	initially	more	productive.Impact	of	access	to	imported	intermediates	on	firm	innovationLSE Business Review: How free trade changes domestic firms’ ability to innovate Page 2 of 3		Date originally posted: 2020-01-29Permalink: https://blogs.lse.ac.uk/businessreview/2020/01/29/how-free-trade-changes-domestic-firms-ability-to-innovate/Blog homepage: https://blogs.lse.ac.uk/businessreview/When	foreign	firms	enter	Widget	Corp.’s	domestic	input	market,	they	provide	access	to	imported	intermediategoods	for	Widget	Corp.	(and	generate	import	competition	for	its	domestic	suppliers).	Access	to	importedintermediates	differs	from	“offshoring”	and	“outsourcing,”	which	involve	delegating	the	entire	production	process	to	aforeign	firm	with	which	Widget	Corp.	does	not	trade.	Most	studies	find	access	to	imported	intermediates	to	have	apositive	and	significant	impact	on	firm	innovation,	and	they	primarily	focus	on	firms	in	developing	economies.	Forthese	firms,	access	to	imported	intermediates	are	likely	to	lead	to	an	improved	production	process	and	learningfrom	more	technologically	advanced	foreign	counterparts.	In	theory,	access	to	imported	intermediates	could	alsoreduce	innovation	by	acting	as	a	substitute	for	process-improving	technologies;	we	find	no	empirical	support	for	thisspeculation.Impact	of	foreign	input	competition	on	firm	innovationForeign	input	competition	is	where	foreign	firms	start	purchasing	from	Widget	Corp.’s	domestic	suppliers,generating	export	opportunities	for	the	suppliers	and	competition	for	access	to	inputs	for	Widget	Corp.	Foreign	inputcompetition	remains	understudied	in	the	empirical	literature.	There	is	some	evidence	that	increased	foreign	demandimproves	the	attributes	of	domestic	input,	leading	to	positive	spillovers	for	downstream	firms	(i.e.,	Widget	Corp.).ImplicationsDue	to	the	complexity	of	trade	flows,	trade	policies	have	intricate	consequences.	A	policy	that	aims	to	protect	somedomestic	firms	may	have	inadvertent	impacts	on	others.	For	instance,	tariffs	on	imports	may	increase	domesticinnovation	by	insulating	firms	from	import	competition;	they	may	also	decrease	innovation	by	restricting	downstreamfirms’	access	to	imported	intermediates.	Moreover,	they	may	lead	to	retaliation	and	reduced	access	to	exportmarkets.	The	risks	of	protectionist	policies	must	be	carefully	evaluated.♣♣♣Notes:This	blog	post	is	based	on	The	Impact	of	Trade	Liberalization	on	Firm	Productivity	and	Innovation,	in	NBERBook	Series	Innovation	Policy	and	the	Economy,	Volume	19,	2019.	Editors:	Josh	Lerner	and	Scott	SternThe	post	expresses	the	views	of	its	author(s),	not	the	position	of	LSE	Business	Review	or	the	London	Schoolof	Economics.Featured	image	by	Soroush	Zargar	on	UnsplashWhen	you	leave	a	comment,	you’re	agreeing	to	our	Comment	Policy.Pian	Shu	is	an	assistant	professor	in	strategy	&	innovation	at	Scheller	College	of	Business,	GeorgiaInstitute	of	Technology.	She	studies	innovation	and	entrepreneurship	with	a	focus	on	science	andengineering	talent.	Dr	Shu	received	a	Ph.D.	in	economics	from	MIT	and	a	BA	in	mathematics	andmathematical	economics	from	Colgate	University.	She	was	an	assistant	professor	at	HarvardBusiness	School	from	2012	to	2017.Claudia	Steinwender	is	an	assistant	professor	of	applied	economics	at	the	MIT	SloanSchool	of	Management	and	is	affiliated	with	the	National	Bureau	of	EconomicResearch	(NBER),	Center	for	Economic	and	Policy	Research	(CEPR),	and	Centre	forEconomic	Performance	at	LSE	(CEP).			LSE Business Review: How free trade changes domestic firms’ ability to innovate Page 3 of 3		Date originally posted: 2020-01-29Permalink: https://blogs.lse.ac.uk/businessreview/2020/01/29/how-free-trade-changes-domestic-firms-ability-to-innovate/Blog homepage: https://blogs.lse.ac.uk/businessreview/

How free trade changes domestic firms’ ability to innovate

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How free trade changes domestic firms’ ability to innovate

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