What is the impact on firms' innovative activities of the removal of barriers to trade? Does the increase in competition arising from trade reforms lead to increases in innovation? This paper attempts to examine the link between trade liberalization and innovation, using firm panel data on the Philippine manufacturing industry. With the framework of Impulliti and Licandro (2009, 2010) as guide, a two-stage approach is tested, where trade and innovation are linked via competition. A reduction in tariffs leads to an increase in competition as price cost margins fall due to the increase in the number of players in the domestic market. With the reduction in price cost margins, profits fall and the productivity threshold above which firms can operate profitably increases. This forces inefficient firms out of the market and resources are reallocated from exiting firms to the higher productivity surviving firms, which innovate at a faster pace. The results show that trade liberalization, has significant positive impact, through competition, on innovation.
Given the crucial role of competition in the relationship between trade liberalization and innovation, it is important for the government to maintain the contestability of markets. The presence of trade barriers or government regulations that limit market entry can create inefficiencies leading to reduced long-term growth. These weaken competition and prevent structural changes from taking place, resulting in resources being tied to low-productivity industries. Weak competition reduces the pressure on firms to adopt new technology or innovate, resulting in low growth of productivity and a loss of competitiveness. Despite two decades of implementing liberalization policy, competition and productivity growth remained weak in the Philippines, not only due to the presence of structural and behavioral barriers to entry, but also to the country's inadequate physical and institutional infrastructure. Due to the fundamental weakness of competition in many major economic sectors, the gains from liberalization remained limited, which slowed down the country's economic growth.

ERIA-DP-2012-05.pdf