Trade and innovation: Unraveling a complex nexus

Abstract This paper reviews the theoretical and empirical economic literature on the innovation effect of international trade. To this end, we focus on technological innovation that targets product characteristics. We highlight three main channels through which international trade can affect innovation by domestic firms: increasing market size, intensifying market competition and facilitating foreign sourcing. While the market size effect of trade on domestic innovation is found to be predominantly positive, the effects of market competition and foreign sourcing are ambiguous and can depend on a variety of factors. Moreover, the impact of trade on innovation is likely heterogeneous across firms.