Innovations and International Trade

Abstract

Innovation plays a key role in the theory of economic growth, but it contains different elements. Roughly, these can be divided into two distinct categories: process innovations and product innovations. The former may also be named “cost-reducing innovations” in the sense that they take place through the discovery of new processes to produce the old products at lower costs. In contrast, the latter may be called “quality-improving innovations” because they occur through the creation of new products with higher qualities. Both categories of innovations are of course important as the engines of economic development, but their implications for economic welfare can be vastly different from time to time and from place to place. In poor economies in the early stage of development, process innovations in the daily necessities contribute significantly to the life of people. In affluent societies in the modem age, however, “it would be a terribly dull life if innovations only reduced costs of producing the same menu of goods and services that now populate their markets (Oi 1997, p. 134).” Product innovations are crucially important in such a situation. This chapter compares the welfare implications cost-reducing and quality-improving innovations in the context of modern international economies in which both poor and affluent countries coexist. Standard textbooks on trade theory teach that a growth in a country’s export industry could be a curse rather than a blessing for its economic welfare. They argue that it brings about a deterioration of its terms of trade, thereby necessarily benefiting its trading partner but possibly damaging its own welfare when the direct gain from the innovation is relatively small. This proposition is, however, based on the implicit assumption that the growth occurs through a cost-reducing innovation and is definitely untenable if it is the outcome of a quality improving innovation. In fact, a quality-improving innovation in any product will generally increase its demand and lead to a rise in its relative price. The traditional literature on trade and growth has apparently overlooked this point because of its unwarranted preoccupation with cost-reducing innovations. In the real world, there are many important quality-improving innovations as well as cost-reducing innovations. For instance, the high rate of growth of the Japanese economy in the 1960s and 1970s may be explained by a series of both types of innovations achieved in important modern manufacturing industries such as steel, automobiles, electric machinery, precision and machine tool instruments, etc., originally imported from the West. The stagnation of the Japanese economy since the 1980s may be attributable to the decrease of quality-improving innovation after the completion of the process of catching up to the West. In the twenty-first century, however, we will perhaps witness a new surge of product innovations related to the conservation of energy and environment such as solar generators and electric vehicles.

This chapter is adapted from “Innovations and International Trade,” Keio Economic Studies, Vol. 46, 1–15, 2010.