# **1. Introduction**

Are firms in Pakistan becoming better at what they do? Is observed GDP growth grounded on firms becoming more efficient? If so, what drives productivity improvements? These questions are relevant. As argued by Krugman (1997) “Productivity isn’t everything, but in the long-run it is almost everything”. The prosperity of countries is associated with the efficiency with which factors of production are used. Understanding productivity dynamics, and their determinants, is crucial.

In a context in which the benefits of integrating with the global economy are being questioned, measuring the impacts that trade and investment integration have on domestic productivity dynamics has relevant implications for the design of trade and investment policies. Importantly, are the gains from integration automatic and inevitable, or do some firms benefit more than others, depending on their capacity to respond to competition or adopt technologies available due to integration? The second question matters for evaluating the role of complementary policies aiming at increased productivity growth.

A growing body of the empirical literature has investigated the effect of reduced distortions in sectors producing inputs upstream on the performance of firms operating downstream either in the form of restrictions to trade or to investment. Typically, restrictions to trade – for example, in the form of tariffs – affect upstream markets producing goods inputs, while restrictions to (foreign) investment could affect both goods and services input provision. One branch of the literature has focused on the role of trade policy distortions and shows that lower tariffs on intermediate inputs increase productivity. Amiti and Konings (2007), for example, use data on Indonesia and find that, (a) lower output tariffs increase productivity by inducing tougher import competition, and (b) cheaper imported inputs also raise productivity via learning, variety, and quality effects. This channel of tariff reforms on productivity through intermediates appears to be stronger than the former channel. For India, Topalova and Khandelwal (2010) find that lower input tariffs played a larger role in boosting productivity than output tariffs during the liberalization process of the 1990s. Yu (2015) provides evidence on the matter for China. Following a related line of argument, Goldberg et al. (2010) find that lower intermediate input tariffs account for a large portion of output growth in India mainly due to the availability of increased varieties of inputs.

Another branch of the literature focuses on distortions in upstream services sectors – in the form of restrictive policies or implementation hurdles which reduce the scope for increased FDI.<sup>3</sup> When relevant intermediate inputs are services, rather than goods, FDI in upstream sectors can play a key role in increasing their availability and quality, or reducing their prices. Indeed, exposure to multinationals that typically display greater productivity levels in upstream sectors has also been linked with learning and with increased incentives to innovate in downstream sectors. For example, Arnold et al. (2016) found sizable effects on the productivity of the firms operating downstream, when foreign entry restrictions in upstream sectors were relaxed in India. Fernandes and Paunov (2012) use data for Chile showing analogous results, while Duggan et al. (2013) conduct the analysis

> 3 There is also a branch of literature that focuses on distortions to investment upstream in goods, as well as in services. See for example, Javorcik (2004).

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