If the gains from trade are small, is it worth facing the distributional consequences of globalisation and the political backlash associated with them? Research by Giammario Impullitti and Omar Licandro, published in the February 2018 issue of the Economic Journal, suggests that accounting for firms'' innovation responses doubles the gains from trade obtained in static quantitative analysis.

In a dynamic model calibrated to the US economy, the authors show that moving from autarky (full economic independence) to the current level of US trade yields a 50% permanent increase in consumption, half of which is due to innovation-driven productivity growth. This result suggests that dynamic gains are of first order importance in evaluating the impact of policies aimed at liberalising or curtailing international trade.

Building a quantitative model for policy analysis requires a theory grounded in a large enough set of relevant empirical facts. Each one of these key facts generally corresponds to a particular channel of gains from trade. The new study focuses on the following facts:

• First, there is a large body of empirical evidence documenting the competition effects of trade. Increasing foreign competition is often found to reduce firm prices, thereby shrinking their profit margins. Lower prices benefit consumers by increasing their purchasing power – the pro-competitive effect of trade.

• Second, the reduction in profits forces some of the less profitable, and less productive, firms out of the market, thereby reallocating market share towards the most productive firms. This selection effect generates an additional channel of gains from trade, as more productive firms charge lower prices.

• Finally, foreign competitive pressure induces firms to invest in innovation to improve their productivity. This innovation effect leads to dynamic gains from trade, as higher productivity growth produces not just a one-off price reduction but also a sequence of reductions across time.

Impullitti and Licandro construct a model embedding all three key channels through which trade can potentially increase average consumption, thereby raising the wellbeing of countries as a whole.

Frontier quantitative trade models consider the first two channels in static economies where the effects of a policy change take place immediately through reallocation of market share across firms and sectors but each firm''s productivity is constant.

The contribution of the new study is to cast the trade model in a dynamic economy where innovation generates technological progress, ultimately spurring productivity growth. Hence, the model is able to measure separately the static gains from trade-induced reallocations and the dynamic gains produced by innovation and long-run productivity growth.

The quantitative exercise simulates a counterfactual scenario where an increase in trade barriers brings the US economy from its current import level – an 8.6% ratio of imports to GDP – to autarky.

The protectionist policy allows US firms to charge higher mark-ups in the domestic market, leading to a 30% increase in the average profit rate (mark-up). The reduction in foreign competitive pressure makes survival easier for less productive US firms in their own market, thereby reducing the average level of productivity.

Weaker competition and selection reduce firms'' incentives to innovate, leading to lower long-run growth: the aggregate growth rate of the economy drops from 1.25% to 0.8%.

Due to the combination of these forces, the average long-run consumption per capita drops by 50%, a dramatic loss. About half of this consumption loss is accounted for by the effect of protectionism on firms'' incentives to innovate, the key source of growth in modern economies. A liberalisation scenario yields the same results but with gains in the place of losses.

The key message of this research is that policy evaluation with static trade models is likely to underestimate significantly the gains or losses from globalisation.


''Trade, Firm Selection and Innovation: The Competition Channel'' by Giammario Impullitti and Omar Licandro is published in the February 2018 issue of the Economic Journal. Giammario Impullitti and Omar Licandro are at the University of Nottingham.