Imports as competitive discipline: The role of the productivity gap

This paper addresses the impact of foreign competition on the competitive advantage of domestic firms, and the role of trade policy. In an endogenous growth framework, it shows that the impact of foreign competition on R and D and productivity depends on the industry's relative position. Trade liberalization promotes innovation and enhances welfare in mature industries, but hinders growth and leads to market exit in infant industries with a large productivity gap. In the latter case, temporary protection promotes the survival of the firm, and increases welfare, at the margin. Hence, we integrate the 'old' argument for the temporary protection of infant industries with the notion that foreign competition fosters innovation and productivity.