Trade Liberalization and Product Innovation: The Dynamic Role of Exporting

How does trade liberalization affect firms' incentives to innovate? We answer this question using China's WTO accession and a dynamic model of firms' joint export and product-innovation decisions. We find that trade liberalization reduced iceberg trade costs by approximately 13.5 percent in the air-conditioner manufacturing industry, which substantially increased the probability of export and product innovation. Moreover, the response is driven primarily by dynamic rather than static incentives. Two dynamic mechanisms are central: exporting and innovating lead firms to predict more favorable transitions to better productivity states and reduce future entry costs, thereby raising the returns to subsequent innovation. Counterfactual decompositions show that these mechanisms account for the majority of the innovation response. For firms in an intermediate productivity state, the direct static effect (without entry-cost saving and state transition) accounts for only 9.2 percent of the total effect of WTO accession. Shutting down state transition leads to 62.4 percent of the total effect, while shutting down entry-cost saving results in 28.5 percent. The results demonstrate that the innovation effects of trade liberalization are substantially amplified by firms' endogenous dynamic responses, highlighting the importance of accounting for state transitions and forward-looking decisions when evaluating the gains from trade.