How trade triggers innovation

In a new paper coauthored with Jesse Perlaopen in new window at the University of British Columbia and Michael Waughopen in new window at New York University, Tonetti uncovers a long-overlooked way in which opening international borders to trade can spark more innovation and growth.

Familiar Subject, Fresh Approach

The study of trade and economic productivity is an old one. Academics have for decades probed the ways in which open borders promote the diffusion of new technologies and ideas. Likewise, they have studied how the expanded markets created by open borders can spur investment in innovation.

But Tonetti and his colleagues recognize a novel third mechanism by which trade feeds productivity growth. Using a formal model, they demonstrate that increased competition from exporting foreign firms pushes domestic laggards to adopt more efficient practices and technologies.

“You can think of it like this: If everyone else is moving ahead faster and you’re standing still, then you’re falling behind faster,” Tonetti says. “And if you’re falling behind faster, you’ll probably choose to upgrade your technology more often.”

Two important nuances in Tonetti’s model helped generate this insight. First, studies of international trade typically argue that open borders benefit large, productive companies that are already exporting their products while grinding under the heel of competition smaller and less productive mom-and-pop shops.

Don’t Just Sit There — Do Something!

“In a traditional model, that’s sort of the end of the story,” Tonetti says. “In my model, a key innovation is that we give those smaller firms some activity they can do in response: Instead of having to sit there and take it, they can get better.”

Second, and related, Tonetti’s model turns off the valve of international idea diffusion. For the sake of argument he and his coauthors assume that ideas don’t travel across borders. The model instead shows how the variegated nature of domestic markets — some firms use best practices while others don’t — creates enduring inefficiencies in markets. The introduction of outside competition shakes these markets up and, to a degree, curtails inefficiencies as domestic firms adopt better domestic technologies.

How much does this matter? Older studies of trade and growth assumed not much, pegging welfare gains from this avenue of innovation at roughly 1%. Tonetti and his colleagues found gains closer to 10%, or an order of magnitude larger.

Tonetti was careful, though, to define his work in a tradition of economics that looks at aggregate well-being: What, for example, would a decision to have more open borders mean for domestic firms? Would it improve or diminish the sum total of their productivity?

What’s This Got to Do with Equity?

He stresses that his results speak nothing to questions of equity, such as: How do open borders affect domestic employment rates in a specific business sector, or geographic region, or demographic group?

“There is a whole separate branch of economics literature on trade that tries hard to study the distributional implications of policy,” he says. “These two complement each other — you want to know what’s happening to the whole pie and you want to talk about how to slice it up.”

With trade, for example, Tonetti notes that a policy of open borders may create aggregate gains, but it also creates winners and losers among individual domestic firms. All boats are not lifted. It is the job of economists to think about ways to distribute these gains, and the job of policymakers to choose what happens.

“It’s probably true that a lot of people in America, and across the world, have been hurt by international trade proliferation,” says Tonetti. “But if that fact stops us from further integrating economies, further lowering trade barriers, then my paper suggests we’re leaving a lot on the table. We just have to put the distributional policies in place to take care of those who are hurt.”