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Microeconomic and macroeconomic implications of firms' internationalization and innovation strategies: the role of demand and informational barriers

Final Report Summary - INTINN (Microeconomic and macroeconomic implications of firms' internationalization and innovation strategies: the role of demand and informational barriers.)

The research carried out in this project has developed along two main lines, namely a firm-level investigation of the determinants of innovation and export decisions and a sector-level investigation of the effects on macroeconomic performance of countries’ global involvement.
1- A microeconomic investigation of firms’ innovation and internationalization activities.
At the microeconomic level, the analysis has focused on the role of a firm’s size on its innovation and internationalization activities. Notwithstanding the larger presence of big and more productive firms in foreign markets, and their relatively better performance in innovation (the so called “size premium”), our analysis shows that small and medium firms’ activities in foreign markets are both large and relevant, and that exporters are more likely to introduce product innovations than non-exporters also at relatively small firm sizes and productivity levels. Typical supply-side factors are not sufficient alone to explain firms’ behaviour. There could be then some unobserved dimensions, in particular concerning the characteristics of the goods they produce, which help both firms’ involvement in foreign markets and their innovation abilities.
i) The role of tastes’ dispersion in destination markets.
A first line of research aimed at explaining SME’s export performance, explores the role of taste diversity, proxied by using country-level ethnic diversity, among other measures, in export destination markets. Our results show that the firm’s size premium is lower the more “diverse” are the markets where a firm exports. This could be explained in different ways. Higher diversity may generate niches in the markets allowing for larger profit margins, helping less productive SMEs to overcome the cost of operating and surviving in those markets. However, higher taste diversity may also imply that goods have to be highly customized and small firms may have a comparative advantage in interacting with diverse consumers, and a larger flexibility in customizing their goods. In both cases, irrespective of its source, e.g. ethnicity but also differences in per capita income levels and income distribution, taste diversity positively affect small and medium firms activities.
A direct implication of these results --to be further investigated-- is that the effect on the survival rate of SMEs of shifting from autarky to trade depends on the degree of taste diversity of the trading partners.
These results also suggest a potential link between migration flows and firm size distribution, an indirect implication which should be further investigated, given the social implications in terms of migration policies.
ii) The role of upstream-downstream relationships in production.
A second possible explanation of the evidence on small and medium firms’ innovation and internationalization activities may be that innovation, in particular product innovation, partly stems from inter-firm relationships. As stressed by business and management studies buyer-supplier collaborative relationships are a fundamental source of mutual learning. Innovation is described as a process that no longer happens exclusively within the firm, but which rather involves the entire supply chain or a network of actors. In particular, users with specific needs are a fundamental source of information for developing new products. Cooperative relationships may emerge when the buyer requires parts and components that must be adapted to his product or process. This channel of product innovation by supplying should be relatively more relevant for small and medium firms which cannot bear alone the costs of carrying out innovation activities.
Intermediate goods, which usually involve complex buyer-supplier interactions, are today estimated to account for about two thirds of world exports. Our analysis documents also that subcontracting is widespread among European firms (about 77% of manufacturing firms produce to order for other firms, on average 82% of their total turnover). Thus, by analysing buyer-supplier relationships, we consider an innovation channel which is potentially relevant to the vast majority of manufacturing firms in Europe.
Using the European survey EFIGE, we provide some empirical evidence that firms carrying out production to order for foreign firms (“production to order exporters”) are indeed more likely to introduce product innovations than subcontractors for domestic buyers.
This suggests that the demand side, where in this case demand is represented by a downstream firm (buyer) producing a highly customized good and therefore looking for a highly customized input, can be a relevant source of product innovation and internationalization for the supplier firm. Interacting with a foreign buyer may be a relatively easy way to enter foreign markets and to start introducing product innovations, enabling small and medium firms to overcome the sometimes prohibitive costs of acquiring the relevant knowledge about the foreign customers’ needs or those of setting up R&D labs. Moreover, foreign buyers are more likely to ask a foreign than a domestic supplier to carry out the product adaptation activity needed to produce the final good, because of lack of information about the characteristics of the input produced by the foreign supplier. This asymmetry in buyer-supplier relationships when developed in different countries generates scope for product innovation by “production to order exporters”.
From the policy point of view, the above results suggest that policy makers may adopt policies targeted at facilitating the international match between downstream and upstream firms located in different countries. Examples of such policies include the reduction of trade barriers (in particular, non-tariff barriers), the reduction of foreign buyers’ costs to search for suppliers abroad and to exchange information, for instance by investing in high-speed internet connections. All these measures would indirectly help supplier firms’ internationalization and innovation activities. On the other hand, policies increasing firms’ production flexibility, (that is reducing the costs of tailoring their good to foreign needs) such as investments in STEM (science, technology, engineering and mathematics) education, public-provided technical assistance, or the provision of public incentives for the creation of innovation consortia could help firms’ attractiveness to foreign buyers. This is particularly relevant for those small-medium firms which do not act on a scale large enough to bear the high cost of R&D, and for which the interaction with foreign buyers represents a primary source of product innovation and an opportunity to internationalize.
As a final consideration, our results suggest that firms’ size distribution reflects also firms’ ability to produce highly customized goods, both intermediate inputs and final goods, and not only firm’s own efficiency in terms of cost competitiveness.
2- Countries’ global involvement and macroeconomic performance.
Following the insights of the firm-level investigation, we have also explored some channels through which the sectoral composition of production and trade may affect a country’s performance at the aggregate level.
The growing relevance of trade in intermediate goods is directly related to the expansion of the international fragmentation of production (IFP), or the development of international production chains stretching across different countries, where the various production stages and the creation of value added for a given final good is taking place in different locations. We explore the relationship between a country’s participation in the IFP and some measures of its aggregate performance, namely the current account and the innovativeness measured by patents per capita, by using the recently released WIOT (World Input-Output Tables) data. Our results show that IFP is indeed a relevant predictor of EU countries’ current account. The current account in EU countries worsens the higher the offshoring to low-income/low-product quality countries, i.e. the lower the production using high-quality inputs. This evidence suggests that when countries import low-quality inputs the potentially negative effect of importing intermediate inputs on the current account is not compensated by the potentially positive effect of gaining competitiveness by offshoring. On the other hand, the higher the offshoring to high-income/high-product quality countries the more the current account improves, suggesting that incorporating high-quality imported inputs in the production allows for the competitiveness channel to prevail. In particular, results are not symmetric for EU Eastern countries and EU-mature economies. The negative effect on the current account of offshoring to low-income/low-product quality countries holds for EU Eastern countries, but not for EU-mature economies, suggesting that both the quality of domestic demand and the segment of competition (low- vs. high-quality) in the foreign markets matter. By contrast, the positive effect of offshoring to high-income/high-product quality countries holds for EU-mature, but not for EU Eastern countries.
Furthermore, we find that the involvement of a country in IFP is positively related to its innovation output the higher the level of R&D stock of the partners. This suggests that IFP can be a channel of technology spillovers. These results hold in particular for developing countries, implying that an international technology transfer from developed to developing countries may be at work.
From a policy perspective, we could conclude that what is relevant for a country’s performance is its ability to enhance its competitiveness through offshoring by selecting the “right” type of partners, which is probably also driven by the reasons behind a country’s offshoring, i.e. learning from partners, importing technology and knowledge versus pure cost saving.
Our results suggest that IFP may be a potential channel affecting the world income distribution, but our work is too preliminary to derive policy implications. In particular, additional investigation is needed to evaluate the overall general equilibrium welfare effects of offshoring, as the impacts on a country’s external position and innovativeness are only two aspects of a much larger picture.
Given the role played by the demand composition found in the firm-level analysis, we further posit a potential “demand channel” driving the secular changes in the sectoral composition of a country, in particular the well documented large shift of employment from tradable to non-tradable sectors. By using EUKLEMS and Groningen 10 sectors data, together with World Bank data and Penn World tables, we show that not only the income level of a country, but also the income distribution is related to the sectoral composition between tradable and non-tradable goods, i.e. services and construction. The higher is a country income level and the within country income inequality, measured by the Gini index, the larger the consumption of non-tradable goods and therefore the share of employment in non-tradable sectors, this having potentially negative effects on a country’s per-capita GDP and on its external position. Nevertheless, in order to understand the effects in the aggregate performance further investigation is needed because this demand channel may also shift consumption and employment composition towards high quality or highly specialized goods, with different implications on the GDP level and trade performance.