# **1. Introduction**

Recent research by Imbs and Wacziarg (2003) showed that economic development is associated with increasing diversification rather than specialization in lower- and middle-income countries. This paper studies one aspect of economic diversification, namely the introduction of new export products during the process of development. In this context, diversification is related to the market failure hypothesis of Hausmann and Rodrik (2003a), which suggests that discovering that a product can be profitably produced in a particular country, where it has never been produced before, creates valuable social knowledge. Production costs and foreign demand are not knowable _ex ante_ , making such a discovery an ‘inside-the-frontier innovation’. Firms that imitate the first mover derive benefits from such discoveries, yet they pay nothing for it. That is, imitation raises the social returns relative to the private returns. While imitation is clearly desirable from a social viewpoint, the first mover can not appropriate all the value created by their investments in discovery as, as this type of innovation can not be protected by the intellectual property rights regimes used to spur on-the-frontier innovation. As entrepreneurs can not appropriate all of the value they create, they underinvest in the experimentation necessary to discover new export opportunities, and consequently the process of productive diversification and private sector development stagnates.

However interesting this theory is, the market failure hypothesis has not been tested empirically. In fact, we know very little about the relationship between the emergence of new export products and economic development in general. This paper attempts to fill this void.

We develop an identification strategy for the existence of market failures affecting inside-the-frontier innovation, or discovery, using disaggregated product-level export data available for a large sample of countries. In addition, we develop a metric for discovery activity and establish empirical regularities that serve to deepen our understanding of the discovery process and its relationship to productive diversification and economic development.

The rest of the paper is organized as follows. Section 2 proposes a minimalist model of discovery and imitation by focusing on potential interactions between the returns to introducing a new product for export and the ease of imitation. Section 3 discusses the data and the methodology for identifying episodes of export discoveries. Section 4 presents various results by proceeding in stages. We first link export diversification with the process of development in the same spirit as Imbs and Wacziarg’s (2003) analysis of the relationship between employment and production diversification and development. In turn, this section contrasts empirical regularities concerning the inside-the-frontier innovation as proxied by our measure of export discoveries, export diversification, and patenting activity and their relationship with the level of development proxied by Gross Domestic Product (GDP) per capita. Likewise, we explore the view that the observed relationship between export discoveries and development is due to structural changes in factor endowments associated with development. The final set of results 1