General Equilibrium Perspectives on Innovation by Firms

My research examines a variety of central questions in international macroeconomics and trade, such as: Does international trade improve welfare by stimulating innovation? To what extent can the increase in globalization account for the observed rise in wage inequality in developed and developing countries? What are the aggregate consequences of reallocating firm‐embedded know‐how across countries in the form of FDI? Why are relative prices across countries so volatile over time? A unifying theme of my research is to develop quantitative models and bring in new data to shed light on these classic questions. Here I take the opportunity to report on the progress of some of my recent and ongoing work in addressing some of these questions. In this work, Andrew Atkeson and I explore a commonly held view that international trade has extra benefits because it stimulates innovation by firms. According to this idea, reductions in trade costs make large firms that export face a bigger global market, which increases their incentives to innovate to reduce costs. Hence, the larger exposure to trade leads to an increase in productivity by some firms, which contributes to raising aggregate productivity and welfare. To assess this view, Andy and I (Atkeson and Burstein 2010a) develop a general equilibrium model that captures the dynamic decisions of heterogeneous firms to exit, export, and invest in innovation to both improve existing products (process innovation) and create new products (product innovation). This model can then be used to aggregate‐up from firm‐level decisions to obtain a deeper understanding of how aggregate productivity should be expected to respond in general equilibrium to changes in the economic environment such as international trade costs. Our model extends Hopenhayn's (1992) and Luttmer's (2007) model of firm dynamics with exit and entry of new firms to include a R&D decision by incumbent firms following Griliches' (1979) model of knowledge capital. We consider an open economy version of these models with fixed and marginal international trade costs, as in Melitz (2003). We propose a simple algorithm to assess the impact of a change in the cost of international trade on aggregate productivity and welfare in the long run. A striking feature of our results is that, across a range of model specifications that we can solve analytically, consideration of the endogeneity of firms' decisions to exit, export, and invest in process innovation have no impact, to a first‐order approximation, on our models' implications …