Trade and innovation

Marc Melitz, Stephen Redding 28 July 2021

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One of the central insights of recent research on innovation and growth is that the pace of innovation is endogenously determined by the expectation of future profits, an idea dating back to Schumpeter (1942) and Schmookler (1966). As international trade is a key determinant of firm profitability, through both the size of the market and the extent of product market competition, it is natural to expect it to play a key role in shaping innovation and growth. In a new paper (Melitz and Redding 2021), we review the theoretical and empirical literature on trade and innovation, focusing on insights from a Schumpeterian perspective. According to this view, growth occurs through a process of creative destruction, such that existing state-of-art technologies are progressively replaced by the next generation of technologies.

Through endogenising the rate of innovation, these theories open up an entirely new channel for potential welfare gains from trade. In addition to the conventional static welfare gains from trade, these theories point towards the possibility of dynamic welfare gains from increases in the rate of innovation and growth. Determining the magnitude of these dynamic welfare gains from trade, the relative importance of different possible mechanisms for them, and whether they involve a permanent change in economic growth (endogenous growth) or a temporary one along the transition path towards a steady state (semi-endogenous growth) remain central questions for research on innovation and growth.

In the existing international trade literature, there is a good deal of consensus about the static welfare gains from trade, defined as the increase in the level of flow utility from country participation in international markets. Traditional theories of international trade emphasise cross-country variation in the opportunity cost of production for different commodities as source of comparative advantage and welfare gains from trade. Specialisation to exploit these differences in opportunity cost gives rise to inter-industry trade, as countries export in industries of comparative advantage and import in those of comparative disadvantage. 

New theories of international trade highlight product differentiation and increasing returns to scale, which can generate welfare gains from trade through both an expansion of product variety and reductions in production costs. The resulting specialisation to realise these economies of scale generates intra-industry trade, in which countries simultaneously export and import similar products within the same industry. 

Finally, theories of heterogeneous firms in differentiated product markets following Melitz (2003) and Bernard et al. (2003) point towards the non-random selection of the most productive firms into international trade and the resulting intra-industry reallocations of resources. The most productive firms expand into export markets while increased competition induces the least productive firms to exit. This generates welfare gains through increased average industry productivity.

While theories of endogenous innovation and trade open the possibility for dynamic welfare gains from trade, there is much less consensus about the existence and magnitude of such changes in countries' rates of innovation and growth. Four main mechanisms for these dynamic welfare gains from trade have been proposed. First, international trade expands the market size accessible to firms. To the extent that innovation involves fixed costs, this expansion of market size can raise the incentive to innovate, because these fixed costs can be spread over a larger number of units of production.

Second, international trade increases product market competition as the producers from different countries enter one another's markets. To the extent that this increased product market competition reduces firm profits, this can depress the incentive to innovate, as in the classic trade-off in industrial organisation between static and dynamic efficiency. However, an important contribution of the Schumpeterian approach has been to uncover a rich nexus of channels through which increased competition can have the opposite effect of raising the incentive to innovate, or generate an inverted U-shaped relationship between innovation and product market competition, as in Aghion et al. (2005).

Third, international trade induces specialisation according to comparative advantage, as in the conventional theories of trade discussed above. If sectors differ in their rates of innovation and growth, this specialisation according to comparative advantage can affect aggregate rates of growth through a change in sectoral composition. However, the implications of this specialisation for welfare are more subtle, since output and consumption growth are not equal to one another in the open economy. Even if a country specialises in sectors with slow output growth, it can enjoy the fruits of its trade partners' more rapid output growth through an ongoing improvement in the international terms of trade. 

Fourth, international knowledge spillovers can directly affect countries' rates of economic growth, and international trade in goods itself can be a conduit through which ideas spread around the world. These knowledge spillovers can facilitate catch-up to the world technology frontier and can accelerate the rate of advancement of this world technology frontier. Trade can influence knowledge spillovers through changing both the set of firms selling in a market and the set of firms producing in a country. Knowledge spillovers may occur serendipitously, or as a result of either direct investment in knowledge acquisition, or more indirectly via imitation of more advanced products (leading to product cycles, in which products are first invented in some parts of the world, and then imitated in others).

In exploring these different mechanisms through which international trade can affect innovation and growth, we distinguish between three key classes of models of endogenous innovation. First, there are models of endogenous innovation through the expansion of product variety (horizontal differentiation), which build on the closed economy framework of Romer (1990) and include Rivera-Batiz and Romer (1991) and Grossman and Helpman (1991a). Second, there is the Schumpeterian approach of endogenous innovation through the improvement of product quality (vertical differentiation), including Aghion and Howitt (1992) and Grossman and Helpman (1991a, 1991b). Third, more recently, models combining elements of both those approaches have been developed. In much of this recent literature, firms supply horizontally differentiated varieties, but these varieties differ systematically from one another in terms of productivity or quality.

Some economic forces are common to variety and quality-based models of endogenous innovation. In both approaches, innovations differ from conventional economic goods in two key respects, as discussed in Jones (2018). First, they are non-rivalrous, such that once an idea has been created, it can be used by anyone at zero marginal cost. Second, they are partially excludable, such that intellectual property rights or intangible knowledge about the implementation of innovations enable researchers to appropriate at least some of the economic return from them. Furthermore, many of the forces that influence the future profits from innovation are common to both groups of models, including the roles of both market size and product market competition.

Other economic forces are quite different between variety and quality-based models of innovation. In particular, creative destruction features much more prominently in the Schumpeterian approach. Since products are vertically differentiated, all consumers agree about which product is preferred at given prices. Therefore, when innovation occurs, the existing state-of-the-art technology is displaced. This property has a number of economic implications. First, creative destruction affects the incentives for innovation for incumbent and entrant firms. In the basic Schumpeterian model, the fact that the existing stream of profits is destroyed by innovation (the so-called replacement effect), implies higher incentives for innovation by entrants who then displace incumbents. 

Second, creative destruction affects the size and magnitude of the externalities from innovation, and hence the divergence between private and social rates of return. When making their endogenous investments in innovation, new entrants do not internalise the externality from the destruction of existing firms' profits. Third, the vertical nature of innovation has important implications for the relationship between incentives to innovate and product market competition. Depending on the distance between firms in technology space, increased product market competition can either depress incentives to innovate (through a discouragement effect) or enhance incentives to innovate (as firms try to escape competition).

While there is a commonly used framework for quantifying the welfare gains from trade in a class of trade models that uses observed domestic trade shares and estimates of the elasticity of trade flows with respect to trade costs, the quantification of these dynamic welfare gains from trade is much more dependent on model structure. Going forward, discriminating between alternative mechanisms for dynamic welfare gains from trade and developing robust approaches to quantifying their magnitude remain exciting areas for further research.

References

Aghion, P and P Howitt (1992), “A Model of Growth Through Creative Destruction”, Econometrica 60: 323–351.

Aghion, P, N Bloom, R Blundell, R Griffith and P Howitt (2005), “Competition and Innovation: An Inverted-U Relationship”, Quarterly Journal of Economics 120: 701–728.

Bernard, A B, J Eaton, J B Jensen and S Kortum (2003), “Plants and Productivity in International Trade”, American Economic Review 93: 1268–1290.

Grossman, G and E Helpman (1991a), Innovation and Growth in the Global Economy, Cambridge MA: MIT Press.

Grossman, G and E Helpman (1991b), “Quality Ladders in the Theory of Growth”, Review of Economic Studies 58: 43–61.

Jones, C (2018), “New Ideas about Ideas: Paul Romer, Nobel Laureate”, VoxEU.org, 12 October.

Melitz, M J (2003), “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity”, Econometrica 71: 1695–1725.

Melitz, M J and S J Redding (2021), “Trade and Innovation”, CEPR Discussion Paper 16264.

Rivera-Batiz, L and P Romer (1991), “Economic Integration and Endogenous Growth”, Quarterly Journal of Economics 106: 531–555.

Romer, P (1990), “Endogenous Technical Change”, Journal of Political Economy 98: 71–102.

Schmookler, J (1966), Invention and Economic Growth, Cambridge MA: Harvard University Press.

Schumpeter, J A (1942), Capitalism, Socialism and Democracy, Routledge.

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Topics:  International trade Productivity and Innovation

Tags:  innovation, Schumpeter, creative destruction, trade, endogenous growth

David A. Wells Professor of Political Economy, Harvard University

Harold T. Shapiro Professor in Economics, Economics Department and School of Public and International Affairs, Princeton University; CEPR Research Fellow; NBER ITI Program Director

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