Innovation When The Market Is Shrinking: Firm-level Responses To Competition From China∗

How does trade liberalization that raises a country’s import competition affect the innovative activity of its firms? We exploit the strong growth of Chinese exports resulting from China’s entry into the World Trade Organization in 2001 as a competitive shock to, specifically, Mexican manufacturing firms. Innovation is captured through information on the adoption of specific production techniques such as just in time inventory methods, quality control, and job rotation. Our results indicate that China’s rise in global trade did not affect by much Mexico’s rate of innovation, which contrasts with the substantial gains that others have found in the case of bilateral liberalization. At the same time, there is a striking heterogeneity in the responses across firms: productive firms innovate more while less productive firms innovate less. This leads to positive selection in that initial differences in firm performance are sharpened by the advent of new competition. We discuss the implications of these findings for theories of trade and innovation. ∗We thank Swati Dingra and participants of the LACEA conference (San Jose, Sept 2010) for comments. The financial support of the World Bank’s Research Support Budget is gratefully acknowledged. †Development Research Group, World Bank, 1818 H Street, NW; Washington, DC, 20433, USA. Email: [email protected] ‡University of Colorado, PO Box 256, [email protected] §The University of Vienna, Hohenstauffengasse 9, A-1010 Austria. Email: [email protected]