The theoretical literature on trade and growth recognises that a firm’s incentives to undertake innovation investments can be affected by their activities in international markets (Grossman and Helpman 1993, 1995, Burstein and Melitz 2013). For exporting firms, the expected return on innovation investments can be larger than for non-exporting firms because of a larger market size, the ability to learn from knowledge spillovers in the foreign country, or because of competitive pressure from exporting firms based in other countries. Restrictions on trade limit the firm’s access to these factors and reduce the payoff they receive from their innovation investments. Government efforts to foster R&D and innovation, and thus economic growth, cannot ignore the complementarity between trade and innovation policy.
While it has been well-documented that firms that operate in international markets are more innovative (Altomonte et al. 2013, Damijan et al. 2017), the causal impact of export market conditions on firm innovation investments remains difficult to quantify. One approach to do so focuses on time periods with trade liberalisations and finds that the resulting reductions in trade costs have a positive impact on firm innovation (Bustos 2010, Lileeva and Trefler 2010, Aghion et al. 2018). A second approach estimates structural models of R&D investment that allow for different payoffs to innovation in the export and domestic markets (Aw et al. 2011, Peters et al. 2018). They find that export market profitability has a large impact on the probability a firm invests in R&D.
In a recent paper (Maican et al. 2020), we extend the structural framework to measure how changes in export market conditions impact both the firm’s decision to invest in R&D (extensive margin) and the level of R&D spending (intensive margin). In this framework, firms invest in R&D to improve their productivity in the domestic and export markets, which raises their future profits in those markets. Additionally, for non-exporters, the R&D-induced productivity gains improve their chances of entering foreign markets.
The returns to R&D can differ in the export and domestic market, depending on how R&D impacts productivity in each market. Firms choose their optimal R&D level by comparing the expected long-run payoff to the incurred cost of the investment. By estimating the decision rule for R&D investment, we quantify how the extensive and intensive margins of R&D investment are affected by export market profits. We also simulate how increased trade barriers reduce firm R&D investment and can offset the gains from innovation policy designed to stimulate R&D spending.
Exporting and R&D investment for Swedish manufacturing firms
With a relatively small domestic market, Swedish firms rely heavily on sales in foreign markets. In manufacturing, export sales account for more than 47% of the sector's total sales. Many Swedish firms produce high-tech products and are significant investors in R&D. Overall, R&D spending equals 3.7% of GDP. This combination of reliance on high-tech products and export markets makes the linkage between exporting and R&D investment particularly important for the future success of these firms. We estimate the model using Swedish firm-level data for 12 manufacturing industries from 2003 to 2010. Six of the industries, including chemicals, vehicles, and electrical machinery, heavily invest in R&D and are classified as high-tech industries, while the remaining six have lower levels of R&D investment and are classified as low-tech industries.
The empirical results show that a firm's R&D investment raises its future productivity in both the domestic and export market, with a larger impact in the export market. Productivities in both markets are highly persistent, implying that R&D expenditures will have a long-lasting impact on future firm profitability. The structural framework provides a natural measure of the expected long-run payoff to R&D investment – the increase in firm value per Swedish krona spent on R&D. Because R&D expenditure has a larger productivity impact in the export market, the expected payoff to R&D increases with the firm’s export intensity. For the median firm in each high-tech industry, this payoff varies from 0.53 to 3.87 for the non-exporting firms but 10.17 to 56.56 for the exporting firms. The higher return to R&D for exporting firms is also seen in the low-tech industries, but the magnitudes for all firms are substantially smaller.
The findings demonstrate a clear positive link between the return to R&D investment and export activities. This suggests that the imposition of trade restrictions can reduce the degree of innovation activities in the economy. Smaller investment in innovation slows productivity growth, reduces firms’ future profit, and further decreases their incentives to invest in the future. This reduction in innovation and in growth represents a source of dynamic losses from the trade barrier.
We quantify the impact of the trade barrier on firm R&D investment by simulating the effect of a 20% tariff imposed on Swedish exports. The results show that the tariff reduces the profit for Swedish firms in the export market and lowers the expected net benefits of R&D by an average of 32.2% in the high-tech industries and 30.4% in the low-tech industries. The lower return to R&D leads to a reduction in R&D spending of 13.9% and 8.9% in the high-tech and low-tech industries, respectively. The results show that, while R&D adjustments occur on both the extensive and intensive margins, most of the adjustments are observed at the intensive margin. Facing an export tariff, Swedish firms continue to invest in R&D, but reduce their level of investment. The reduction in R&D investments causes a decrease in the firm productivity levels, which results in lower export intensity and participation. Similar to the R&D response, the export adjustments occur on the intensive margin as well.
Adding a retaliatory 20% tariff on imported materials raises firms’ production cost and causes profits in both the export and domestic market to drop. Similar to the response pattern created by the export tariff, R&D investment, export activities, and future productivity fall. The magnitude of the response, however, is a multiple of that observed from the export tariff alone.
Our analysis confirms and quantifies the link between trade activities and R&D investment. The long-run payoff to R&D investment is higher for firms that are active and operating more intensively in export markets. This leads to higher R&D spending by these firms than by their non-exporting counterparts. The linkages between the firm's trade exposure and the level of R&D investment are important for policymakers to recognise when fostering innovation. A rise in restrictions to free trade reduces the returns to R&D and can offset the effectiveness of innovation policies designed to stimulate R&D investments.
Aghion, P, A Bergeaud, M Lequien and M J Melitz (2018), "The Impact of Exports on Innovation: Theory and Evidence”, NBER Working Paper 24600.
Altomonte, C, T Aquilante, G Bekes and G Ottaviano (2013), "Internationalization and Innovation of Firms: Evidence and Policy”, Economic Policy 28(76): 663-700.
Aw, B Y, M J Roberts and D Y Xu (2011), “R&D Investment, Exporting and Productivity Dynamics”, American Economic Review 101(4): 1312-1344.
Burstein, A and M Melitz (2013), "Trade Liberalization and Firm Dynamics", in Advances in Economics and Econometrics Tenth World Congress, Applied Economics, Econometric Society Monographs Vol 2, Cambridge U.K.: Cambridge University Press.
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Damijan, J, Č Kostevc and M Rojec (2017), "Exporting Status and Success in Innovation: Evidence from CIS Micro Data for EU Countries", The Journal of International Trade & Economic Development 26(5): 585-611.
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Maican, F, M Orth, M J Roberts and V A Vuong (2020), "The Dynamic Impact of Exporting on Firm R&D Investment", NBER Working Paper No. 27986.
Peters, B, M J Roberts and V A Vuong (2018), "Firm R&D Investment and Export Market Exposure", NBER Working Paper No. 25228.