Endogenous Productivity Change

Gustafsson and Segerstrom (2010) extended the variety expansion model, considering households with preferences for varieties of goods, to an R&D-based heterogeneous firms’ model. They introduced the difficulty of R&D, creating a semi-endogenous growth model in which the scale effect disappears. Under a symmetric two-country setting, firms are divided into export, local and non-production firms, depending on the degree of labour productivity. Entrepreneurs enter the market as one of the firms after subtracting their productivity, determined by a Pareto distribution. Trade liberalisation improves the productivity of the industry by encouraging the least productive local firms to exit and the most productive local firms to enter the export market. This is called the cleansing effect of trade liberalisation. This lowers the relative R&D difficulty and reduces the number of varieties because it increases the fixed R&D cost. Furthermore, due to the cleansing effect of trade liberalisation, the price index falls as the supply of goods increases and welfare improves through increased consumption. In a full endogenous growth model, trade liberalisation raises fixed R&D costs and lowers the economic growth rate.