Trade Policy and Innovation

Abstract

We consider a two-country model with a firm in each country where firms across countries are heterogeneous in their capacity to innovate. We study process-improving R&D under various trade policy shocks. We find that the benefits of trade liberalization and trade protection differ across firms. One of the main results we obtain is that unilateral trade protection reduces R&D of the protected firm when that firm is highly innovative while it spurs R&D if the protected firm is lowly innovative. These predictions are in line with recent empirical evidence on firm level responses to trade protection. In contrast to earlier results for symmetric countries, our model shows that bilateral protection tends to reduce R&D levels.