While it is generally agreed that trade liberalization promotes productivity growth in developing countries, greater exposure to imports does not necessarily promote innovation. This column reports evidence from Chile that the positive impact of foreign competition is likely to be greater, the larger the share of firms close to the frontiers of technological progress and productivity. Boosting firms’ capabilities and their access to resources that can help them respond to competition may be a key complement to policies of greater openness to trade.
The widely accepted positive relationship between competition and productivity growth sits somewhat uncomfortably with the inconclusive body of research evidence on the relationship between competition and innovation.
This is becoming increasingly relevant to debates about countries’ openness to trade and their economic growth performance. Despite extensive evidence suggesting that trade liberalization increases productivity, recent evidence from the United States, Canada, and Europe finds negative or unclear impacts on innovation from rising exposure to imports.
There are conceptual reasons to think that, in practice, effects could vary greatly across countries. One notable study offers a synthesis of the view that competition is necessary to get entrepreneurs out of bed in the morning, set against the argument first made by early 20th century economist Joseph Schumpeter that higher rents increase the return to innovation.
The research finds that firms far from the productivity frontier may behave in line with Schumpeter’s expectation and retrench with greater competition, but firms closer to the frontier may see innovation precisely as a way to escape from competition. This raises the question of whether the net impact of competition on innovation might differ depending on the distribution of firms’ abilities within an economy and, in particular, how many are close to the technological frontier.
The authors follow an emerging research agenda in making use of the shock of Chinese import penetration to study its impact on innovation in a prominent upper-middle-income country.
Chile is perhaps uniquely suited as a case study. First, it offers a clean experiment to explore the effects: it is the iconic ‘textbook’ open economy which, as elsewhere, saw levels of competition shock due to a major increase in import penetration from China. But distinct from many episodes of trade liberalization, this shock was not accompanied by other sector-specific reforms. Hence, any effects are likely to be purely due to differential exposure to increased foreign competition across sectors.
Second, the authors draw on a matched firm production/innovation panel data set that covers a wider range of innovation inputs and outputs than previously possible and uses product price data. Thus, allowing them to generate measures of mark-ups and efficiency (physical total factor productivity - TFPQ) that correspond more closely to the concepts of rents and technological leadership envisaged in work in the Schumpeterian tradition.
Overall, the authors find that the impact on innovation is, on average, negative across virtually all measures. However, they also find striking differences across firms. Figure 1 divides the sample by ‘leaders’ and ‘laggards’, and then by whether mark-ups rose or declined with the increase in Chinese competitions for four measures of innovation.
Research and development (R&D), process innovation, product innovation, and quality all fall for laggards and the effect is exacerbated when mark-ups are falling. R&D, product innovation, and quality all rise for leaders, and more so if mark-ups are increasing. Therefore, the view of the importance of proximity to the technological frontier and the Schumpeterian view of the importance of rents both receive support.
The results are consistent with other findings. For example, recent analysis of ‘the China shock’ finds a detrimental effect on French firms’ sales and patenting for Chinese competition in output markets – with the negative impact being concentrated in low-productivity firms, defined as those below the median level of revenue TFP.
A different study finds that sectors close to the technological frontier, entered into by greenfield foreign firms, experience increased patenting. However, it has a weak or negative effect in laggard industries, again where leaders are defined as the top 50%.
What is striking in the Chilean case is that when leaders are also defined this way, there is no positive impact on innovation. There are positive effects only when leaders are defined as the top 10% of the distribution of TFPQ or efficiency, which accounts for 25% of industrial value added.
Intuitively, this is consistent with countries further from the frontier having few firms near the frontier. But it also means that the impact of competition on innovation will be lower than in advanced countries, and potentially net negative, as appears to be the case in Chile.
Clearly, a finding of limited incumbent rise in innovation and perhaps lesser confidence in previous findings of increased productivity with trade liberalization does not imply the need to reduce competition. Competition works through other margins, such as the reallocation of resources from low-productivity plants to high-productivity plants, and through the entry of more productive plants and the exit of less productive ones.
Research by the same authors shows that over 60% of the gains in TFPQ in Chile arose precisely from entry and exit. Other work finds that during the early phases of the Chilean reforms, much productivity growth occurred precisely because of reallocation of resources and the entry of new firms, which rings true given the extraordinary levels of protection and distortions being unravelled at the time.
At the same time, the evidence does suggest that the positive impact of trade liberalization is likely to be greater, the larger the share of firms close to the technology progress and productivity frontier. Hence, raising the capabilities of firms and their access to resources that can help them respond to competition may be an important complement to policies of greater openness to trade and competition. As recent work suggests, this might include extending managerial consulting programs, strengthening local innovation systems, and ensuring access to longer-term finance.
Ana Paula Cusolito is a Senior Economist currently working at the World Bank Group (WBG) in the Finance, Competitiveness, and Innovation Global Practice. Her research interests focus on firm-level productivity, the digital economy, innovation, entrepreneurship and trade.
Alvaro Garcia Marin is an assistant professor at the Universidad de los Andes, Chile. He holds Ph.D. in Management from UCLA. His main research interests are international trade, macroeconomics and productivity.
William F. Maloney is Chief Economist for the Latin America and Caribbean (LAC) region. Previously he was Lead Economist in the Development Economics Research Group, Chief Economist for Trade and Competitiveness, and Chief Economist for Equitable Growth, Finance and Institutions (EFI).