Abstract

The availability of rich firm-level data sets has recently led researchers to uncover new evidence on the e€ects of trade liberalization. First, trade openness forces the least productive firmto exit the market. Secondly, it induces surviving firms to increase their innovation efforts and thirdly, it increases the degree of product market competition. In this paper we propose a model aimed at providing a coherent interpretation of these findings. We introducing firm heterogeneity into an innovation-driven growth model, where incumbent firms operating in oligopolistic industries perform cost-reducing innovations. In this framework, trade liberalization leads to higher product market competition, lower markups and higher quantity produced. These changes in markups and quantities, in turn, promote innovation and productivity growth through a direct competition e€ect, based on the increase in the size of the market, and a selection e€ect, produced by the reallocation of resources towards more productive fims. Calibrated to match US aggregate and firm-level statistics, the model predicts that a 10 percent reduction in variable trade costs reduces markups by1.15 percent, firm surviving probabilities by1 percent, and induces an increase in productivity growth of about13 percent. More than 90 percent of the trade-induced growth increase can be attributed to the selection effect.