Firm Innovation under Import Competition from Low-Wage Countries

In recent years, manufacturing firms in the United States have faced increasing import competition from low-wage countries, especially China. Does this competition hurt or help innovation by firms? This paper studies the effect of the surge in imports from China on innovation in the US manufacturing sector. We first propose a simple theoretical framework which generates an inverted U-shaped curve of innovation on imitation, that is based on the endogenous price elasticity of demand for the product in a Cournot model. We then take the theoretical prediction to the data by combining patent, firm, and trade data during 1990-2010 for US publicly-listed firms in the Compustat dataset. We find consistent evidence that Chinese import competition had an inverted-U effect on firm innovation, as measured by patent counts and citation-weighted patents. Our result suggests that import penetration positively affects firm innovation when import penetration is less than 60%, but this positive effect is inverted when import penetration is more than 60%. This inverted-U relation persists when we instrument import competition in the US by using Chinese import penetration in the United Kingdom and when we test the robustness of the results by including sector-specific trends. We further investigate this inverted-U relationship between import competition and innovation by considering industry heterogeneity and find that the inverted-U relationship is steeper for firms in high-tech industries and industries with a long quality ladder