DP17083 International Trade and Innovation Dynamics with Endogenous Markups
Over the last decades, the United States has experienced a secular increase in market concentration and markups, as well as a doubling of the trade-to-GDP ratio. Our paper argues that these trends could be linked, pointing out an “innovation feedback effect” of trade. Lower trade costs increase innovation incentives for large global firms, and as the winners of the ensuing innovation races increase their technological advantage over global competitors and local firms, concentration and markups rise. To make this point formally, we develop a dynamic general equilibrium trade model with endogenous markups and endogenous innovation. We calibrate our model to US manufacturing data, and show that an increase in trade openness (consistent with the one observed between 1989 and 2007) increases the aggregate markup by 3.5 percentage points. This increase is entirely due to firms’ innovation response: without this response, markups would have fallen by 4 percentage points.