The impact of trade liberalization on productivity distribution under the presence of technology diffusion and innovation

Abstract We develop an international trade model in which firms' productivity is affected by technology diffusion and innovation, and the model generates an endogenous Pareto productivity distribution. Each new entrant to the market randomly searches for and meets incumbents and then adopts their existing technology, which is considered technology diffusion. The incumbents adopt the newly developed frontier technology, which is considered innovation. The endogenous response of the productivity distribution to trade liberalization differs depending on whether the incumbents possess a high or low frequency of innovation. In an economy with a low frequency of innovation, trade liberalization increases both the Pareto exponent and the exit-cutoff productivity level. This higher Pareto exponent shifts the weight of the productivity distribution from the upper-tail area to the area around the new lower productivity bound, which generates productivity losses. The dominant productivity gains through the increasing of exit-cutoff productivity increase average productivity across all firms. However, in an economy with a high frequency of innovation, trade liberalization increases moderately or decreases both the Pareto exponent and the exit-cutoff productivity level. The reduced Pareto exponent generates productivity gains by accumulating highly productive incumbents. In total, however, trade liberalization generates weaker productivity gains or productivity losses on average productivity across all firms due to the moderately increased or reduced exit-cutoff productivity. Consequently, the welfare gains from trade are smaller in economies with high frequency of innovation than in those with low frequency.