Trade, firm selection, and innovation: the competition channel

The availability of rich ?rm-level data has led researchers to uncover new evidence on the effects of trade liberalization. First, trade openness forces the least productive fi?rms to exit the market; secondly, it induces surviving fi?rms to increase their innovation efforts; thirdly, it increases the degree of product market competition. In this paper, we propose a model aimed at providing a coherent interpretation of these ?ndings, and use it to asses the role of fi?rm selection in shaping the aggregate welfare gains from trade. We introduce ?firm heterogeneity into an innovation-driven growth model where incumbent fi?rms operating in oligopolistic industries perform cost-reducing innovation. In this environment, trade liberalization leads to lower markups level and dispersion, tougher fi?rm selection, and more innovation. Calibrated to match US aggregate and fi?rm-level statistics, the model predicts that moving from a 13% variable trade costs to free trade increases the stationary annual rate of productivity growth from 1:19 to 1:29% and increases welfare by about 3% of steady state consumption. Selection accounts for about 1/4th of the overall growth increase and 2/5th of the welfare gains from trade.