Economic theory tells us that international trade can bring lots of benefits as we specialize according to our comparative advantage (“static gains from trade”).  Theory also suggests that trade can lead to dynamic gains through transfer of technology, competition and economies of scale.

The Organisation for Economic Cooperation and Development (OECD) argue that these dynamic gains are also major drivers of innovation.  This is important because much of the rise in living standards since the Industrial Revolution and especially in recent decades has come through innovation.  And innovation can also play an important role in solving all sorts of problems like climate change and infectious diseases, and in providing opportunities to people the world over to have better lives.

So what is innovation?  The OECD defines innovation to be “the implementation of a new or significantly improved product (good or service), or process, a new marketing method, or a new organisational method in business practices, workplace organisation or external relations”.

Importantly, open trade is not the only driver of innovation.  Many policies like R&D policy, intellectual property rights, education and human resource policy, and financial market policy contribute too.  So does plain human ingenuity!  Trade-related innovation will only flourish where the overall policy environment is conducive to change.  And also where countries have a strong absorptive capacity thanks to, for example, strong investments in human resources.

Open trade (and investment) contributes to innovation as imports (especially capital and intermediate goods) embody technology, and as imported foreign capital equipment is usually cheaper than locally produced.  For example, Samsung imported semiconductor manufacturing equipment from the US and Japan when creating its dominance in DRAMs (Dynamic Random Access Memories).

Developed countries tend to export high-technology goods compared to developing countries.  But even the US, which is at the global frontier in scientific equipment, imported roughly one-quarter of the analytic and scientific instruments used domestically in 2006 ($ 1.9 billion).

Imports of information technology products are very closely linked with the ability of firms to innovate, that is, to introduce new products, services, business processes and marketing methods.  This is because the process of innovation is about bringing together new and existing knowledge, and different resources, which are often in different organizations, parts of the organization or individuals.  And information technology can help us do just that.

The introduction of mobile phones to fishermen in India led to an increase of 8% of profits for fishermen and a decline of 4% in consumer prices as fishermen could use the mobile phones to call several nearby markets from their boats to establish where his catch will fetch the highest price.

Another important source of technology is patents which can be traded directly through licensing.  International receipts for intellectual property (including patents, copyrights, trademarks, etc.) increased from USD 10 billion in 1985 to approximately USD 110 billion in 2004 with more than 90% of the receipts going to the three major regions: the European Union, Japan and the United States.

Licensing increases the efficiency of innovation processes by putting inventions in the hands of those best capable of commercializing them.  It allows the licensor to recoup some of the costs of developing the technology, while the licensee gains the right to use the technology, and possibly gain access to detailed information on the technology depending on the terms of the contract.

Imports compete with local production thereby improving efficiency.  Such competition can also provide an incentive to innovate.  An interesting example is the Intel Corporation, the largest semiconductor manufacturer in the world.  During the early 1980s, Intel began to slip in some of its markets as highly innovative Japanese competitors challenged Intel's position.  In response, Intel decided to focus on microprocessors, and then succeeded in dominating the upper-end PC and other markets.

Exporters can become more innovative through exploiting economies of scale, and learning by exporting.  Exports increase market size, and can enable R&D and other expenditures to be recouped over a bigger volume (domestic and foreign sales).

The Finnish market is so small that Nokia had to seek growth overseas.  Today, it is Finland’s largest enterprise and is one of the world’s largest manufacturers of mobile devices.  A combination of early deregulation of the Finnish telecommunication market, a favourable trade and investment environment such as integration of Finland into the EU Single market, successful implementation of a global corporate technological and marketing strategy, and some supportive government policies have allowed Nokia to evolve from a national/regional company in 1990 (30% of sales were domestic and 60% in Europe) to a truly global company (1% of sales are domestic and 30% Europe) at present.

Nokia now produces mobile phones in 10 manufacturing facilities in a total of 9 countries (Brazil, China, Germany, Finland, Hungary, India, Mexico, Korea, and UK), sources components from over 30 economies around the world and sells mobile devices in 150 countries.  Supply chain management and logistics has become one of Nokia’s core competencies.  Sources of innovation can emerge in different companies in different parts of the world, and Nokia increasingly considers itself as an extended enterprise with an orchestration capability.

Exporters can also become more innovative through “learning by doing” (or "learning by exporting").  They may for example work closely with foreign customers who provide information about product designs, materials, labeling, packaging and shipping, assistance to reduce costs and control quality, help in the factory layout, etc.

Numerous studies have found that firms who export are more productive than purely domestic firms.  Exposure to international markets either has a strong positive effect on firms’ incentives to innovate or on their ability to innovate.

The capacity for trade to stimulate innovation is facilitated by the change in systems of innovation.  In the past, there was a "closed innovation" model of R&D departments developing technology for use only within the company.  This model is now obsolete. Firms are moving towards a more open system of innovation where innovation is created through interactions within and outside the company (suppliers, competitors, customers, universities, research organizations).

In this new paradigm of "open innovation," firms source ideas and technology externally and become more permeable to the flow of knowledge from outside the company. They also find new ways of exploiting their own inventions, such as through spin-off companies, licensing technology or releasing intellectual property in the public domain.  Freer trade and investment facilitates increased interaction with suppliers, competitors, and customers.

IBM provides a good example. Until the 1980s, IBM did everything in-house from R&D, system development, component manufacturing, system and subsystem assembly, software development, to distribution and servicing.

But IBM realized that it was no longer realistic to tightly control use of its component technologies since abundant specialized knowledge had dispersed to other companies and countries.  It also changed its global strategy as innovation is increasingly drawn from all over the world.  Today IBM has become a globally integrated enterprise where company functions are realised where it is most efficient. For example, in servicing a Swiss client, a Swiss office can receive computer data support from India, software support from Brazil, and procurement services from Budapest.  IBM work “flows” to the location where it can best be done.  Free trade and investment enable freer interaction between suppliers, competitors and customers.

Advances in technologies in communications and logistics, and the decline of trade and investment barriers around the world have allowed production processes to be fragmented, an innovation in its own right. The production process can now be divided into discrete tasks which can be conducted in either geographically concentrated locations or distant locations.  Companies no longer need to excel in a wide range of areas in order to create value.  Fragmentation facilitates even deeper specialization and through this more innovation.  Leading brands of clothing can enhance their innovation by focusing on the design and marketing of products, and not expending resources on manufacturing.  These global value chains have become a key conduit for technology transfer and innovation.

Innovation gives birth to technological advantage, which together with differences in factor endowments, are the source of comparative advantage which in turn drives trade. Thus technology gaps have been found to be one determinant of trade and investment.  And open markets are a great source of innovation which benefit innovative firms.

So let’s innovate and trade, and trade and innovate!

References:

Papers from the OECD Global Forum on Trade, Innovation and Growth, 15-16 October 2007

http://www.oecd.org/site/0,3407,en_21571361_38863817_1_1_1_1_1,00.html