# **III. Innovation and trade are intertwined**

To be able to compete in global markets, firms need to invest in innovation to deliver continuous improvement in their productivity. This can be achieved in different ways, such as decreasing production costs, introducing new products and services, adopting new technologies and improving the process of production and delivery. Throughout this process, the availability of a qualified labor force and the quality of management practices are indispensable for firm performance, notably for firms in developing economies that engage in trade (Bloom et al, 2021; Bastos et al, 2018; McKenzie and Woodruff, 2018).

Beyond the new technologies that advance the global production frontier, innovation is a broader concept, which includes the introduction of new or improved products and processes. It can be in the form of improvements in technical specifications, components and materials, software development, design, user-friendliness, and other functional characteristics of existing goods and services (OECD Frascati Manual, 2015). It can also entail new or significantly improved production and delivery methods, such as the automation of work or organizational improvements through software to manage inventories or improve delivery. This will be considered to be (catch-up) innovation, even when it is only new to the firm but not necessarily to its market.

On the one hand, innovation and managerial quality have a direct impact on the quality of output, allowing firms to compete and survive on global markets.<sup>9</sup> On the other hand, access to international markets, and especially to a globalized system of production through GVCs, opens up new ways for firms to learn from trade partners and improve their productivity further. Two main mechanisms between trade and innovation can be distinguished in the literature: self-selection into trade; and learning-by-exporting. This will also depend on the direction of the causal relationship.

The idea of a self-selection process argues that only the most productive firms are able to cover the sunk costs of exporting and engage in trade (Bernard et al, 2012; Wagner, 2007; Melitz, 2003). Trade participation requires significant and continuous investment in innovation, which may also influence the degree of internationalization (Teruel et al, 2021). For example, the use of new technologies can enable new marketing and sales channels or reduce costs related to entry into foreign markets – factors that hamper smaller firms with limited resources. Lowering the cost of entry into trade can make the selection process work more efficiently. More firms will be able to compete with international counterparts, while the least productive firms, faced with expanded competition from home and abroad, will exit the market.

The idea behind the learning-by-exporting mechanism is that exporters gain knowledge from exposure to foreign markets and practices, allowing them to grow and increase their efficiency. The presence of factors that affect entry costs into trade or preferential access to foreign markets – for example, specific regulatory barriers, the time to clear customs, and direct informal or formal payments – will make it more difficult for firms to learn from global markets, adopt new technologies and become more innovative. This is particularly true for firms that are part of GVCs and may gain

> 9 On average, firms that invest in innovation and engage in trade are better managed. Enterprise Surveys include detailed questions on core management practices related to addressing problems arising in operations, monitoring of performance indicators, production targets and incentives rewarding staff performance. This information can be summarized in a normalized management index, where a higher score reflects better practices.

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