“A Model of Trade and Productivity Improvement through Knowledge Capital Formation”

Chun-Kai Wang, Shandong University 

This paper develops an intra-industry trade model with productivity improvement to examine the effect of trade on productivity improvement of an industry. Productivity improvement is modeled as an exogenous process, but the rate of improvement is endogenously determined by the speed of public knowledge capital formation. The paper considers two types of knowledge capital formation – through idea flows from incumbent firms or the cumulative R&D efforts in the industry. The paper also factors in international technology diffusion due to trade by allowing foreign firms' contribution to knowledge capital formation. The selection effect of trade will drive out the least productivity firms and enlarge high productivity firms. Through the interaction of the selection effect of trade and knowledge capital formation, trade sometimes promotes the rate of knowledge capital formation, and hence the rate of productivity improvement, and sometimes does not. The net effect of trade on productivity improvement depends on the specification of knowledge capital formation and the efficiency of international technology diffusion.