Council of Economic Advisers Blog

4 Ways Trade Drives American Innovation

Creating good jobs at good wages is central to the President’s strategy of middle-class economics. Trade is an integral component of that strategy. Here’s why: 

U.S. trade agreements reduce foreign barriers to U.S. exports, increasing export opportunities for U.S. businesses. Trade also expands choice for consumers and producers, raising real wages so that American families’ budgets go further. In fact, by one estimate, reductions in U.S. tariffs since World War II have contributed an additional 7.3 percent to American incomes. And that’s just a few examples of how trade benefits our economy. As I mentioned in my speech at Brookings earlier today, values-driven trade agreements, like the Trans-Pacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (T-TIP), will put the United States at the center of integrated trade zones making up nearly two-thirds of the world economy. 

Supporting the middle class is more than just increasing real wages and household budgets. It’s also about increasing the productivity of American workers, or the amount of output a worker can produce per hour. Growth in productivity is profoundly important for the living standards of middle-class Americans. Consider this: If productivity had not slowed down starting around 1973, but continued growing at the rate it did between 1953 and 1973, then incomes today would be 58 percent higher, which is equivalent to a difference of roughly $30,000 per household every year. The best way to increase long-term productivity growth, and realize the tremendous benefits it brings in terms of wages and living standards, is through innovation. 

That’s why trade is so important. Trade promotes innovation, which drives the productivity growth needed to expand U.S. businesses, create more good jobs, and boost American wages. One recent review of the evidence calls the relationship between globalization and productivity growth a "robust finding."

And negotiating high-quality trade agreements with strong and enforceable labor standards, while adopting complementary domestic policies, can help ensure that we make these potential benefits a reality for the American people.

Trade promotes innovation and productivity growth in two ways: by increasing the efficiency of the innovation process—helping us bring more innovations to market, faster and at lower prices—and by increasing the rewards that an innovator realizes when their new idea succeeds.    

Increasing Innovative Productivity 

​​1. Trade Increases the Flow of Ideas: Trade can expose both exporters and importers to new ideas and novel tools, materials, or techniques that make them more productive. Some of this learning is simply copying, as when a firm adopts pre-existing technology or know-how. At the same time, since roughly half of all U.S. imports are inputs into the production process, imports can reduce firm’s costs by making a greater variety of goods available at lower prices, and that can lead American businesses to expand production and employment. Academic research shows that what a country gains from international trade is multiplied substantially when the benefits of cheaper and more varied imported inputs are taken into account. Put differently, inputs often embody new ideas, and this helps ensure that imports represent a complement to, rather than a substitute for, American production.

2. Trade Allows for Specialization in Research and Development (R&D): Trade can also increase innovative productivity—the amount of knowledge produced per unit of R&D investment—by allowing innovators to specialize. For example, if engineers at Company X focus on improving memory chips, and engineers at Company Y focus on improving microprocessors, the R&D productivity of each firm may be higher, leading to better and cheaper computers than if each company had to improve both components simultaneously. One recent study of R&D specialization shows that strengthening foreign intellectual property protection, as TPP would do, leads to more outward licensing from the United States, where U.S. companies allow other companies to use their ideas, products, or processes in exchange for royalty payments.

Increasing Incentives for Innovation

3. Trade Increases Access to Markets: International trade allows companies to access a larger market, which yields more profit for a given level of innovation, and therefore raises the incentive to innovate. For example, economic research finds that firms with experience in foreign markets have a greater probability of R&D investment.

4. Trade Promotes Competition: Trade can also stimulate innovation by making markets more competitive. The Nobel Prize-winning economist Kenneth Arrow famously pointed out that a monopolist has less incentive to innovate than a firm in a competitive industry, because the monopolist’s innovations do not allow it to “steal” business from competitors. By bringing companies into a worldwide marketplace, trade greatly increases the incentive for a firm to innovate in order to win business from its competitors, reinforcing the market-size effects discussed above.

Both the economic theory and the evidence demonstrate that trade has a positive impact on innovation, which would also increase long-run productivity growth. Increases in innovation and productivity growth are two key factors by which we can raise middle-class incomes. This relationship only increases the importance of negotiating trade agreements with strong and enforceable labor and environmental standards in order to capture the considerable benefits of increased innovation and productivity. TPP and T-TIP will do just that.