that if a firm is close to the productive frontier by innovating it will prevent entry of potential foreign competitors.<sup>5</sup> However, if a firm is far from the productive frontier then it does not have any chance of preventing a foreign competitor from entering and taking over its market. In such a model, tariffs reduction increases the entry threat and boosts the incentives of “advanced” firms to innovate in order to preempt the potential foreign entry. For these firms, the increased competition reduces more the pre-innovation profits than post-innovation profits because if the firm does not innovate it risks losing all its market due to the entry of the foreign competitor. At the same time the consequences for less productive firms are very different because the increased entry threat reduces the post-innovation profits more than the pre-innovation ones. In fact, the “laggard incumbents” (i.e. less productive) cannot prevent the entry of foreign competitors, even when able of innovating succesfully because they are too far from the productive frontier.

Also, related to this paper is the large set of studies arguing that increased competition puts pressures on “slacking managers” and pushes them to reduce the X-inefficiency (Martin 1978, Martin and Page 1983, Leibenstein 1978). However, all these studies rely on a set of restrictive assumptions and normally assume that firms are homogeneous (Rodrik 1988).

Our work is clearly linked to previous empirical studies analysing the effect of competition on innovative activities and productivity growth even if the earlier studies could only rely on industry-level data (Gerosky 1990, Haskel 1992). Even more relevant to our study are the more recent analysis using firmlevel data to evaluate the impact of competition on productivity and innovation (Nickell 1996, Disney, Haskel, and Heden 2003) as well as the studies evaluating directly the impact of trade liberalization on firm-level productivity (Tybout and Westbrook 1995, Pavcnik 2002, Fernandes 2007, De Hoyos and Iacovone 2006). However, as previously mentioned, these studies focus on the average effect of liberalization and do not account for the possibility that this effect could different across heterogenous firms. Two notable exceptions, that we are aware of, are Schor (2004) Lileeva and Trefler (2007) that allow for the impact of liberalization to be heterogenous across different firms but use a different methodology from the one adopted in this paper.

In the same spirit of our study, a couple of recent papers analysed the impact of FDI spillovers and 5 Foreign competitors are assumed to be at the frontier, therefore when they enter the domestic market they force domestic firms that are not at the frontier to exit because they can produce the same good more efficiently. Another possibility is that even if foreign firms don’t produce exactly the same good their entry on the domestic market can increase the elasticity of substitution of domestic consumers and push mark-ups of domestic firms down, in this case only more productive firms would be able to survive in the more competitive environment. The bottom line is that increased competition will affect the elasticity of demand and therefore the markup of domestic firms. In fact, enhanced import competition can also shift the demand for domestic varieties in and, even with fixed markups, domestic firms are worse off as they have to spread their fixed costs over a reduced output.

4