The Effects of Trade Liberalization on R&D, Industry Productivity and Welfare When Firms Are Heterogeneous

This paper develops an oligopolistic model of international trade with hetero-geneous firms to examine how trade liberalization affects R&D investment, industry productivity and social welfare. We identify three effects of trade liberalization on industry productivity: (i) a direct effect through changes in R&D; (ii) a scale effect due to changes in firm size; and (iii) a selection effect due to inefficient firms leaving the market and efficient firms becoming ex-porters and expanding their overall market share. We show how these effects operate in the short run when market structure is fixed, and in the long run when market structure is endogenous. Among the robust results that hold for any market structure are that trade liberalization (i) decreases (increases) R&D for high (low) trade costs; (ii) increases firm size if trade costs are high; (iii) induces a reallocation of market shares within the industry; (iv) raises consumer surplus; and (v) raises exports. JEL classification: F12, F1