Trade Liberalization, Export and Product Innovation

Abstract

This paper studies firms' optimal response to a trade liberalization shock in terms of export and product innovation both theoretically and empirically. We find that trade liberalization, namely China's WTO accession, reduces iceberg trade cost by around 13%, thus promoting export participation. Subsequently, it affects firms' product innovation through both contemporaneous and dynamic channels. First, it incentivizes firms to innovate as the marginal benefit of innovation for exporting firms is higher than that for non-exporting firms. Second, as a firm starts to innovate, it predicts to have a higher probability of moving to a better productivity state and can save the entry cost of innovation in the future, resulting in additional dynamic benefits which are quantitatively substantial in our estimations. Such an innovation-promotion effect is an unintended consequence of trade liberalization.