Market Size and Innovation in China
Abstract
To understand the current and future impacts of Chinese competition on OECD firms one must understand the trajectory of quality improvements among Chinese exporters. Rising quality has been documented by Brandt and Thun (2010), Manova and Zhang (2012), Brandt et. al (2012) and Sutton and Trefler (2016). What has been the source of this upgrading? While considerable attention recently has been devoted to improved access to foreign intermediate inputs (e.g., Brandt et. al, 2012; De Loecker et. al, 2016), we investigate a channel that is known to be important in many other contexts, namely, the size of the firm’s market. By ‘market’ we mean combined domestic and foreign markets.As shown by Acemoglu and Linn (2004) in a domestic context and Lileeva and Trefler (2010) in an international trade context, an increase in the size of the market available to a firm leads the firm to invest in innovation. We conjecture that these market-size effects are precisely what drive innovation in China. To investigate, we use Chinese firm-level data matched with R&D data, patent data, international transactions data and domestic highway data to examine whether China’s rising quality can be explained by rising rates of innovation and whether rising rates of innovation can be explained by growth in the domestic Chinese market (as measured by highways) and by improved access to foreign markets (as measured by foreign demand and by foreign tariffs against China). Our initial work strongly suggests that both domestic and foreign market size matter and that the latter is the more important of the two.
Throughout, we emphasize allow for the possibility that investments in innovation (the ‘treatment’) have heterogeneous impacts on innovation (‘the outcome’). We thus control throughout for observed and unobserved firm heterogeneity.