A Trapped-Factors Model of Innovation

We explain a counter-intuitive empirical finding: firms facing more import competition do more innovation. In our model, factors of production are trapped inside a firm. When low-wage import competition removes the market for a firm’s current products these trapped factors then become idle within the firm. This reduces the shadow value of these factors as inputs into innovation or the production of new goods. This lowers the opportunity cost of innovation, leading firms to invest more in research to create new goods. Hence, in the presence of trapped factors, firms facing more import competition increase their rates of innovation. The extra innovation induced by trapped factors induces a small permanent increase in aggregate output, consumption, and welfare. Performing a quantitative analysis we estimate a trade liberalization increases long-run OECD growth by 0.2% from to 2.0 to 2.2%. In addition along the transition path trapped factors lead to an extra 0.2% of growth for a decade, i.e. a 2.4% rate of growth in the short run.