Tuan A. Luong - tuanluong.com · Tuan A. Luong Shanghai University of Finance and Economics May 14, 2013 SHUFE Luong (Institute) Innovation and Trade liberalization May 14, 2013 SHUFE

The impact of trade liberalization on Innovation

Tuan A. Luong

Shanghai University of Finance and Economics

May 14, 2013SHUFE

Luong (Institute) Innovation and Trade liberalization May 14, 2013 SHUFE 1 / 52

Introduction

Traditional models of international trade show trade liberalizationimprove welfare via reallocation of resources and economies of scale.

These gains are static and can not be the long-run driver of economicgrowth.

Economists now focus on dynamic gains from trade: innovation.

Our research question: What is the impact of trade liberalization oninnovation?


Introduction

The spillover effect

The Schumperterian effect

The escape-competition effect

The backward-linkage effect

The economies of scale effect

The cannibalization effect


Grossman Helpman AER 1990a

Two sectors X and Y.

Only in one sector (X) that learning by doing occurs: effi ciencyimproves with output growth.

Trade policy can have different impact on innovation:

Protection on sector X will drive the resource to this sector, raisingmore innovation.Protection on sector Y will drive the resource away from sector X,retarding innovation.


Grossman Helpman 1991

Two manufacturing sector X and Y and one R&D sector.

Two factors: skilled and unskilled labor.

Sector X is assumed to be more skill intensive than sector Y.

Protection for sector X will attract skilled labor, making them moreexpensive and therefore retard innovation.

Protection for sector Y will make skilled labor relatively cheaper,therefore speeds R&D.


Grossman Helpman EJ 1991

From autarky to free trade, Northern manufacturing is released toSouthern firms. This results in labor reallocation to R&D sector,raising innovation in the North.

Higher innovation growth in the North means there are lessmanufacturing output in the North, or less profit per variety in theNorth: the rate of return for innovation is lower.

Moreover, higher innovation growth implies more varieties producedworldwide, and therefore world spending rises.

Optimal household saving decision dictates that world interest ratehas to rise.

Therefore there is a gap between investing in R&D in the North andthe risk-free bond rate of return: this gap can only be explained by ahigher rate of immitation in the South: the rate of return of a newproduct in the North is lower because it is copied in the South.


Grossman Helpman EJ 1991 (cont.)

When the government (both in the North and in the South) imposesome trade policy (tariffs, subsidies), mark-up (which is fixed) doesnot change.

As a result, prices and therefore profit of each new product does notchange.

The incentives of finding a new product (either via innovation orimmitation) stay the same.

Hence, trade policy here does not change the steady-state ofinnovation and immitation rates.


Spillover effect

each research project generates not only a patentable blueprint for itsperpetrator, but also a nonappropriable contribution to the stock ofknowledge.

because knowledge is a non rival input, Romer (1990) assumes thatevery researcher has free access to the total stock of knowledge.

The stock of knowledge A(t) evolves over time as

dA (t)dt

= HtAt

where Ht is the supply of skilled labor.


The form of spillover

Learning by doing (Grossman and Helpman AER 1990): moremanufacturing activities raise the knowledge stock

International spillover: Contact with foreign producers (Grossmandand Helpman EER 1991): the more the two countries trade, thehigher the knowledge stock.

National spillover: The innovation efforts of domestic producers(Grossman and Helpman EER 1991).


Evidence on the spillover impact

The stock of knowledge could be accessed to those within the area(local or national spillover) or to everyone worldwide (internationalspillover).

Coe and Helpman EER 1995: both national and international spilloverare present.

They suggest that in large countries national spillover is moreimportant.

Whereas in small countries international spillover is more important.

Coe and Helpman Hoffmaister EJ 1997: developing countries who dolittle in R&D could benefit substantially from R&D in developedcountries.


Trade with uneven innovation (Grossman and Helpman1991)

When the two countries have different rate of innovation, the countrywith higher rate of innovation will capture a larger share of the worldmarket (through its increasing number of goods).This increasing of world market raises the prospect of the firm’s profitin this country.The firm therefore has more incentive to introduce new goods.By contrast, the country with lower rate of innovation will see itsshare in world market shrink, lowering the profit of a new product,and therefore lowering the rate of innovation.When spillover is national in scope, the size of the country dictatesthe rate of innovation: bigger countries learn faster, therefore havehigher rate of innovation.History also plays a role here: countries that start early have highercumulative knowledge.


Grossman Helpman EER 1991

Knowledge comes from local product development and frominternational exchanges (measured by trade volumes):

K = nφ

(Tn

)T: cumulative trade volume; n: the number of varieties.When trade volumes grow slower than output: the influence of tradeon knowledge stock goes to zero. In this case trade policy has NOimpact on innovation.When trade volumes grow faster than output: trade policy onlyaffects the speed to the steady-state, but not the steady-state itself.In other words, countries that are open to trade converge faster to thesteady state. Again trade policy does not have a long term impact oninnovation.When trade volume and output grow at the same rate in the longrun: they show that the ratio of cumulative trade volume over outputrises after trade liberalization, which increases knowledge stock.Luong (Institute) Innovation and Trade liberalization May 14, 2013 SHUFE 12 / 52

Aghion, Bloom, Blundell, Griffi th, Howitt (QJE, 2005)

There is a final consumption good, and an infinite number ofintermediate goods.

Each intermediate goods can be supplied by 2 producers:

in a leveled sector (neck and neck), the 2 producers have the samelevel of technologyin an unleveled sector, one firm (the leader) is ahead in terms oftechnology relative to the other (the follower).

The competition is Bertrand: price competition.


Aghion, Bloom, Blundell, Griffi th, Howitt (QJE, 2005)

In the unleveled sector, the leader graps all the market profit due toits technological superiority.

In the neck and neck sector, there are 2 scenarios:

If the two firms collude, they share the market profit.If they do not collude, their profit is 0.

The probability of collusion is the inverse degree of marketcompetition.


The escape competition effect

When the market is competitive, it is hard to collude with thecompetitor.

In this case, the firm has an incentive to innovate to set it apart fromits competitor and grap all the profit.

This is called "the escape competition effect": more competitionincreases the innovation rate.

This effect works in neck and neck sectors: in other words, itsstrength is higher in these sectors.


The Schumperterian effect

There is also the Schumperterian effect at work:

more competition reduces the profit gap between the leader and thefollower.as a result, the follower has less incentive to catch up with the leader.according to this effect, more competion reduces the innovation rate.

This effect is stronger in leveled sectors.


The inverted U-shape

Starting with an initial low degree of competition:

The firms in neck and neck sectors have little incentive to innovate toescape from the competition.As a result, if the industry is at leveled sector (neck and neck), it willstay there for a long period.The unleved sector will become leveled as soon as the followerinnovates (which it will because the profit gap with the leader is large).In this situation, the escape competition effect dominates because weare in the leveled state: more competition raises the innovation rate.


The inverted U-shape

Now we move to a situation with higher degree of competition:

The firms in neck and neck sectors have high incentive to innovate toescape from the competition.As a result, if the industry is at leveled, it will become unleveled whenthe innovator becomes the leader.By contrast, if the industry is unleveled, the follower has no incentiveto close the gap with the leader.In this situation, the Schumperterian competition effect dominatesbecause we are in the unleveled state: More competition lowers theinnovation rate.


Aghion, Blundell, Griffi th, Howitt, Prantl (ReStat, 2007)

Similar to the previous set-up.

2 firms in each industry: one leader and one follower.

The follower is one step behind the leader in technological progress.

Innovation only allows the firm to move one step forward.

A new firm can enter the industry with the most advanced technology.


Aghion, Blundell, Griffi th, Howitt, Prantl (ReStat, 2007)

We still have the escape competition effect here: the firm wants toinnovate to escape from the competitor.

Since the gap between the follower and the leader is fixed, there is noSchumperterian effect.

But there is another effect: the entry of a new firm could discouragethe leader to innovate.

This is more true when the leader is several steps away from thefrontier (e.g. the technological level of the foreign firms) becauseinnovation can only enable the leader to move one step ahead whichis not enough to catch up with the new entrant.

In other words, competition raises the innovation rate in sectors thatare close to the technological frontier but has a negative effect in thelagged sectors.


Javorcik (2004)

FDI boosts innovation due to the spillover effect:

domestic firms can copy and/or learn from the foreign technologiesworker turnovercompetition effect: domestic firms have to "cut the slack and fat"

The spillover effect depends on the type of FDI


Horizontal FDI

With horizontal FDI, the foreign firms and the domestic ones competein the same sector.

As a result, the foreign firms have the incentive to preserve theirtechnology superiority:

intellectual property right (IPR)trade secrecypay high wages (Aitken et al., 1996; Sourafel Girma et al., 2001)choose countries with high degree of property rights


Vertical FDI

With vertical FDI, the foreign firms and the domestic ones DO NOTcompete in the same sector. Instead, the foreign firm benefits fromthe improved performance of the domestic supplier.

As a result, the foreign firms have the incentive to:

directly transfer knowledge, provide technical assistance, etc.require better product quality and on-time delivery, which provideincentives to domestic suppliers to upgrade their productionmanagement or technologygive access to new and better inputs to local suppliers.increase demand for intermediate products, which allows local suppliersto reap the benefits of scale economies.


Bustos (2011)

New technology (innovation) helps the firm reduce the variable costs.Therefore when the firm raises its scale (output), it has moreincentive in investing in new technology (the economies of scale).

When trade liberalization takes place, productive firms can sell in theforeign market and expand their scale, while less productive firmsshrink (to the extent that some of them have to quit).

As a result, exporters innovate more than non exporters.

Also, firms in industries that face big tariff cuts innovate more.


Dingra (2012)

A firm can supply more than one products (or varieties). For example,Coca Cola offers 3500 products (as of July, 2012) all over the world.

Therefore there are 2 dimensions of innovation:

Product innovation: finding new productsProcess innovation: cutting the production costs

As discussed above, process innovation is subject to the economies ofscale: higher sales motivate this type of innovation.

However, product innovation is subject to the cannibalization effect:new products compete (and cannibalize) the existing productssupplied by the same company.


Dingra (2012)

Trade liberalization intensifies the competition with the presence offoreign companies.

The domestic firms react to this by lowering product innovation.

At the same time, trade liberalization enables domestic firms tooperate in the foreign market.

The economies of scale imply that domestic firms will invest more onprocess innovation.


Summary

Trade policy leads to a reallocation of resources: depending onwhether the required resources (human capital) moving in or out ofthe learning sector that trade liberalization could induce more or lessinnovation.

If spillover is national in scope, trade liberalization imply moreinnovation in the country that has a higher rate of innovation and lessinnovation in the other country.

If spillover is international in scope, trade liberalization imply moreinnovation only when trade volumes and output grow at the samerate.


Our differences

We see from above that the two main channels through which tradeliberalization affects innovation are reallocation of resources andspillover.

But these two channels are disconnected in the literature.

In our paper we combine these two channels and include another one:the Schumperterian effect.

In the literature, resources reallocated between countries or sectors(Grossman and Helpman 1991). Here reallocation of resources occursbetween firms within the sector.

Spillover can take place at different degree, depending on the types ofinnovation.


Preview of our results

Trade liberalization could lead to more or less R&D investment in thecountry. In particular, trade liberalization generates more knowledge(thanks to more R&D investment) if and only if the spillover effect isstrong enough and investment in R&D is suffi ciently effi cient.

Trade liberalization affects the firm’s R&D via two channels: theSchumpeterian effect and the spillover effect.

We can show that the second channel is the dominant force.

The impact of trade liberalization depends on the firm’s productivity:more productive firms receive bigger shocks.


The model

One country, one type of factor: labor.

Labor wage is chosen to be the numeraire w = 1.


CES demand

The utility of a representative agent in each period is:

U =

∫i

θ1σi (qi )

σ−1σ di

σσ−1

where i is the product index with quality θi . With this utility, the demandfor each product is given by:

qi = θi

(piP

)−σ EP

where P is the true price index:

P =

Z∫0

θip1−σi di

11−σ


Production

The firm has two activities: Manufacturing and R&D

Manufacturing: a la Melitz (2003) with fixed production cost,Pareto-distributed productivity.

R&D: Following Romer (1990) Grossman and Helpman (AER 1990b)the labor cost to improve product quality is given by

I (θ) =θγ

K α,γ > 1, α > 0

K: stock of knowledge, γ: the inverse effi ciency in R&D, α: thedegree of spillover.


Quality costs

It is fairly common in the literature to assume decreasing returns toscale for quality (i.e. γ > 1): it becomes extremely diffi cult toachieve exceptional quality.

Romber (1990) Grossman and Helpman (AER 1990b) assume α = 1.We want to introduce different types of R&D. In particular, accordingto Grossman and Helpman (EJ 1991), a firm needs to learn how toproduce a new product.

If this is a new one, it is called innovation; if the product alreadyexists somewhere in the market, it is called immitation.

From this definition, it is clear that the spillover effect is stronger forimmitation than for innovation.

In other words, innovation has a lower α than immitation.


Research and Development (R&D)

The quality cost plays a role of a fixed cost. Indeed, when γ→ ∞, allthe firms choose one quality level θ = 1 and we have the Melitz(2003) case.

We assume here that the stock of knowledge are specific to theregions in which they have been invented.

In other words, it depends on the amount of innovation taken in theeconomy. In other words

K =∫

θγ

K αdG (ϕ)


Firm behavior

Pricing strategy:

pi =σ− 1

σci

Profitπi = Bθi ϕ

σ−1i − f − I (θi )

where B = (σ−1)σ−1σσ Pσ−1E indicates the market demand.

Quality chosen

θi =

(BK α

γ

) 1γ−1

ϕσ−1γ−1i = θ (ϕi ,B,K )


The determinants of Quality

The firm chooses to supply high quality product when

the market demand is highwhen the stock of knowledge is highwhen productivity is high


Equilibrium

Zero profit condition πi = 0 or

Bθ (ϕ0,B,K ) ϕσ−10 =

θγ (ϕ0,B,K )K α

+ f

Free entry condition

fE =∫

ϕ0

[Bθϕ1−σ − f ]dG (ϕ)

The equilibrium, characterized by two unknowns (P, ϕ0) can besolved from the two conditions above.


The knowledge stock

By definition

K =∫

ϕ0

θγ

K αdG (ϕ)

= K−α

(BK α

γ

) γγ−1 ∫

ϕ0

ϕ(σ−1)γ

γ−1i dG (ϕ)

In other words, we have

K = Dϕ

kα

γ−1 −1

0

with D =[

kϕk

(σ−1)γγ−1 −k

] 11− α

γ−1(

fγ−1

) γγ−α−1


The determinants of knowledge stock

The knowledge stock increases with the productivity cut-off only ifα > γ− 1Indeed, a higher productivity cut-off implies a reallocation of laborfrom the closing firms to the surviving firms.

Since the surviving firms are more productive and therefore engagingin more R&D, this reallocation of resource leads to more knowledgegenerating if R&D cost is low (low γ)

Moreover, more knowledge could lower R&D costs when the spilloveris strong (high α), which encourages the firms to engage in moreR&D.


The impact of trade liberalization

Two identical countries in every aspect.

This assumption is not crucial in our analysis. Rather it is chosen fortechnical reasons.

Since the countries are symmetric, w = w ∗ = 1.

We assume that spillover is national in scope.


The equilibrium

The triplet (ϕ0, ϕ∗0,P) where ϕ∗0 denote the foreign cut-off (or theexport cut-off) characterize the equilibrium.

We have three conditions:Zero domestic profit π0 = Bθ0ϕσ−1

0 − f − I (θ0) = 0Zero export profit π0 = Bθ∗0ϕ∗σ−10 − f ∗ − I (θ∗0) = 0Free entry fJ (ϕ0) + f

∗J (ϕ∗0) = fEThese three conditions solve for the three unknowns.



Trade liberalization induces:

a smaller market demand B due to the fall of the price indexhence, the domestic productivity cut-off is higher.


The impact of trade liberalization on aggregate R&D

By definition, knowledge stock is the total national R&D investment

K =∫

ϕ0

θγ

K αdG (ϕ)

= K−α

(BK α

γ

) γγ−1 ∫

ϕ0

ϕ(σ−1)γ

γ−1i dG (ϕ)

= Dϕ

kα

γ−1 −1

0

Trade liberalization, which raises the productivity cut-off ϕ0 couldlead to higher or lower aggregate R&D investment, depending on theparameters α and γ.


The impact of trade liberalization on aggregate R&D

Grossman and Helpman (AER 1990a): protection for the sector wherelearning occurs will drive up the R&D investment.

We show here that depends on:

whether the spillover is strong enough (high α)whether labor is effi cient in R&D activities (low γ)


The impact of trade liberalization on the firm’s R&D

A smaller market demand leads to a fall in R&D (the Schumpeterianeffect).

But a higher productivity cut-off could lead to a rise in R&Dinvestment (reallocation of resources and spillover effect).

We can show that the second effect dominates the first one.



From the zero profit condition we have B = γγ−1 f ϕ1−σ

0 therefore wecan write the impact of tariff reduction on market demand B as

∂B∂τ= − (σ− 1) B

ϕ0

∂ϕ0∂τ

> 0

From K = Dϕ

kα

γ−1 −1

0 we have the impact of tariff reduction on theknowledge stock

∂K∂τ

=k

αγ−1 − 1

Kϕ0

∂ϕ0∂τ



Since θi =(BK α

γ

) 1γ−1

ϕσ−1γ−1i = θ (ϕi ,B,K )

∂θ

∂τ=

1γ− 1

θ

B∂B∂τ+

α

γ− 1θ

K∂K∂τ

= −σ− 1γ− 1

θ

ϕ0

∂ϕ0∂τ

+α

γ− 1k

αγ−1 − 1

θ

ϕ0

∂ϕ0∂τ

=

[α

γ− 1k

αγ−1 − 1

− σ− 1γ− 1

]θ

ϕ0

∂ϕ0∂τ

When γ > 1 and α > γ− 1 then αkα

γ−1−1= k (γ−1)

1− γ−1α

> k (γ−1)γ > σ− 1



When reallocation of resources and spillover effect is positive (i.e.tariff reduction generates more knowledge in the country) tradeliberalization induces more R&D investment within the firm.

Otherwise, the firm engages in less R&D.



The impact is different across firms.

In particular, the impact is higher for high productive firms.

Indeed, from ∂θ∂τ =

[α

γ−1k

αγ−1−1

− σ−1γ−1

]θ

ϕ0

∂ϕ0∂τ and since ϕ0 and hence

∂ϕ0∂τ do not depend on ϕ we have

∂2θ

∂τ∂ϕ=

∂θ

∂τ

∂θ

∂ϕ


Concluding remarks

In this paper we reinvestigate the impact of trade liberalization oninnovation, both at the country and at the firm level.

We combine the Schumpeterian, reallocation of resources, spillovereffects.

We introduce different degrees of spillover effects.


Concluding remarks

Trade liberalization could lead to more or less R&D investment in thecountry. In particular, trade liberalization generates more knowledge(thanks to more R&D investment) if and only if the spillover effect isstrong enough and investment in R&D is suffi ciently effi cient.

Trade liberalization affects the firm’s R&D via two channels: theSchumpeterian effect and the spillover effect.

We can show that the second channel is the dominant force.

The impact of trade liberalization depends on the firm’s productivity:more productive firms receive bigger shocks.


International spillover

We can follow Grossman and Helpman (EER 1991) to modelizeinternational spillover: trade volumes raise the degree of contact withforeigners, increasing the scope for learning.

Therefore, tariff reduction which increases trade volumes will increasethe stock of knowledge in the country. This in turn helps the firmlower their R&D costs, encouraging more R&D activities.

It is therefore expected that the spillover effect, when positive, stilldominates the Schumpeterian effect.


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Tuan A. Luong - tuanluong.com · Tuan A. Luong Shanghai University of Finance and Economics May 14, 2013 SHUFE Luong (Institute) Innovation and Trade liberalization May 14, 2013 SHUFE