Being part of a trading area like the European Union (EU) not only generates the usual gains from specialisation – with more production and investment – but it can also have benefits in terms of innovation and productivity. This is possible because by accessing foreign markets, firms can scale up production and dilute the costs of innovation.

These are the central findings of a study by Carlos Daniel Santos, which is published in the August 2017 issue of the Economic Journal. The research results are an indication that leaving a trading area can reduce overall innovation, besides generating a reduction in production and investment.

What happens to innovation and productivity when a country decides to leave a trading area? This study suggests that a 25% increase in trade costs is expected to reduce innovation by half and productivity by 4% for an export-oriented industry composed of small companies, as in the Portuguese moulds industry.

The reason for this decline is the fall in market access and a very competitive environment. Since innovation is subject to large ''sunk costs'', the reduced market access generates a reduction in the gains from innovation. This reduction is larger for industries in more competitive markets.

The large set-up costs of innovation are one of the reasons why overall, most innovative activity is conducted by large firms. Having access to larger markets allows competitive companies to gain scale and specialise. This creates proper conditions for the development of innovative activities.

The author of the new study analyses innovation using a framework in which firms have to pay an upfront sunk cost to conduct innovative activities. The sunk costs of research and development (R&D) in the Portuguese moulds industry are estimated to be about three million euros on average, while an average firm sells products worth about 1.5 million euros per year.

Estimates from the analysis are then used to perform the counterfactual exercise of increasing trade costs by 25% to show how this translates into a fall of 50% in total production, a decrease of 13% in the number of firms and, most importantly, a 50% reduction in innovation and a 4% fall in productivity.

The 25% increase in trade costs is in line with the estimated reduction in trade costs between ''periphery'' and ''core'' EU countries after EU integration (Beltramo, 2010).

These counterfactual estimates are consistent with the performance of the Portuguese moulds industry between 1994 and 2004. During that period, the industry benefited tremendously from access to European car manufactures, which translated into a 240% increase in production and a 140% increase in exports.

An exit from the EU, as was debated in Portugal during the 2011 sovereign debt crisis, would reverse these gains.

''Sunk Costs of R&D, Trade and Productivity: The Moulds Industry Case'' by Carlos Daniel Santos is published in the August 2017 issue of the Economic Journal. Carlos Daniel Santos is at Nova School of Business and Economics, Lisbon, Portugal.