Offshoring and Firm-level Innovation

We develop a two-country general equilibrium model in which heterogeneous firms have access to offshoring and innovation as two alternative ways of reducing production costs. We use our model to answer the question whether better offshoring opportunities lead to more or less innovation at the firm level. We show that switching into offshoring increases firm-level innovation activities when the level of openness of the economy is high, and reduces them if the economy is less open. Via general equilibrium effects, a reduction in offshoring costs unambiguously reduces the innovation activities of non-offshoring firms, whereas innovation in infra-marginal offshoring firms may go up or down. Our paper provides a rationale for contrasting evidence on the relation between offshoring and innovation found in the empirical literature.