Globalisation, heterogeneous rms and endogenous

investment
Gonzague Vannoorenberghe

University of Mannheim
This draft: 03/11/2008
Abstract
This paper develops a Melitz (2003) type model where heterogeneously pro-
ductive rms can decide on a level of investment in process innovation in order
to increase their productivity. This intensive investment decision gives additional
insights about the empirical relationship between rm size, export status and in-
vestment. I show that trade liberalisation aects rms choices in dierent ways
depending on their export status and on the investment technology. In addition,
the model addresses three recent empirical puzzles about standard heteroge-
neous rm models: (i) the negative relationship between rm size and Tobins Q
(Nocke and Yeaple (2006)) (ii) the change in the skewness of the size distribution
of rms when trade costs decrease (Nocke and Yeaple (2006)) (iii) the increase in
the mass of consumed varieties following trade liberalisation (Baldwin and Forslid
(2006)).
Keywords: Process innovation, Firm heterogeneity, Trade liberalisation
J.E.L. classication: F12

Department of Economics, University of Mannheim, L7,3-5 Mannheim, D-68131, Ger-

many. Phone: +49 621 181 1797. e-mail:gonzague@uni-mannheim.de
1
1 Introduction
Models of heterogeneous rms have, in the last years been at the core of most
theoretical developments in international trade. Their popularity is based
on their ability to match a number of well-established stylised facts linking
rm characteristics, such as size or productivity, to their export behaviour.
These models moreover provide a new rationale for gains from trade. They
suggest that trade liberalisation leads to a reallocation of productive factors
from inecient rms, which exit the market, to ecient rms, which export
more. This source of gains from trade, which increases the productivity of the
economy, has been conrmed by many studies
1
. However, empirical evidence
points to another channel of productivity gains that occurs within rms,
and not only through a reallocation of factors between rms as explained
by Melitz (2003). This suggests that rms can aect their productivity by
investment, which is the purpose of this paper.
I develop a model `a la Melitz (2003) in which heterogeneously productive
rms can decide on a level of investment in process innovation (thereafter
investment) in order to increase their productivity. This decision is con-
tinuous in the sense that each rm decides how much to spend and is not
restricted to a binary decision between investment and no investment. The
rst contribution of this paper is to examine the investment decision of all
rms and how trade liberalisation aects it. Under minimal assumptions for
a well-behaved problem, I obtain a number of predictions about investment
and rm characteristics that are empirically well established. Larger export-
ing rms invest more than average and rms which enter the export market
raise their investment. I derive new results for the impact of trade liber-
alisation on innovation spending. Following a marginal trade liberalisation,
small, non-exporting rms decrease their investment since they nd it more
dicult to recoup their costs. Large exporting rms on the other hand nd
it protable to invest more as they increase their sales on the export market.
Depending on the properties of the innovation technology, I show how the
rm-level innovation intensity adapts following trade liberalisation. If the
technology is such that large rms innovate proportionately more, exporting
rms, who expand their production, increase their innovation intensity and
non-exporting rms decrease theirs. This same property of the technology
allows to provide a new micro-founded rationale and clear conclusions for the
eect of trade on aggregate R&D intensity.
The second contribution of this paper is methodological. I show that
1
see among others Pavcnik (2002), Treer (2004) and Bernard et al. (2006).
2
the main results of Melitz (2003) are unaected by the introduction of a
continuous investment decision. The changes in the cut-o levels, price index,
or welfare are qualitatively similar to these of Melitz (2003).
Third, I examine a number of recent puzzles to the Melitz (2003) frame-
work and show how the model can address them. Indeed, a number of empir-
ical facts are still at odds with the standard heterogeneous rms framework.
(i) Nocke and Yeaple (2006) argue that trade liberalisation has reduced the
skewness of the domestic size distribution of rms. They nd that a de-
crease in trade costs does not aect all rms proportionately, and that the
size dierential between two given rms tends to decrease. In the original
Melitz (2003) model, all rms face the same proportional reduction in their
domestic sales
2
, which makes it impossible to explain this fact. (ii) Nocke
and Yeaple (2006) also show that the relationship between the Tobins Q of
a rm and its size is empirically negative, and not positive as suggested by
a straightforward extension of the standard model. (iii) Agur (2007) and
Baldwin and Forslid (2006) point out that in Melitz (2003), under the com-
monly used Pareto distribution, the mass of consumed varieties decreases in
both countries following trade liberalisation
3
. This is at odds with empirical
evidence as presented by Feenstra (2006) and Broda and Weinstein (2006).
I show in the present framework that the sensitivity of investment relative
to rm size, which is a direct consequence of the properties of the invest-
ment function, can play a substantial role in explaining the puzzles. Indeed,
if trade liberalisation induces rms of dierent sizes to adapt their optimal
investment level in dierent proportions, the above puzzles can be - at least
partially - explained.
This model relates to the rapidly growing literature on trade with het-
erogeneous rms, which follows the seminal contribution of Melitz (2003).
A number of recent papers have allowed rms to take an additional invest-
ment decision in order to improve their productivity. Yeaple (2005), Ekholm
and Midelfart (2005), Bustos (2005) or Navas and Sala (2007) allow rms
to choose between two dierent production technologies: a low productivity,
low cost technology, and a high productivity, high cost technology. This gen-
erates an endogenous correlation between exporter status and investment, in
which large exporting rms nd it protable to invest, while small unpro-
ductive rms do not invest in technology. However, a discrete decision is too
restrictive to explain a number of observed facts. It appears that following
2
The only channel that aects domestic sales is the decrease of the price index, which
has the same proportional impact on all rms.
3
Under the assumption that xed costs of exporting are larger than xed costs of
domestic production.
3
trade liberalisation, the largest exporters continue to scale up their spending
in innovation
4
, which should not be the case if they had already adopted the
high technology. The eects on the size distribution or on the investment
intensity of rms as a function of size are also much poorer in that type of
model, and insucient to explain the aforementioned puzzles.
Costantini and Melitz (2007) develop a model of discrete investment de-
cision in a dynamic framework, but they focus on the dynamic adjustment
of rms to trade liberalisation and on the causality between export and in-
vestment decision. Ederington and McCalman (2006) use a dynamic model
of trade liberalisation with ex-ante identical rms which can choose between
two technologies. The use of the high technology gradually diuses among
rms, at a speed aected by trade liberalisation. The time dimension intro-
duces an element of continuity, which makes their approach slightly closer to
mine, but they restrict their attention to the speed of diusion of technology.
Their use of a discrete investment decision however bears similar problems
to those mentioned earlier.
Van Long et al. (2007) and Atkeson and Burstein (2007) provide to my
knowledge the only two models making the investment decision of rms con-
tinuous. The rst is very dierent from the present setup, since it assumes
strategic interaction where the investment decision is made before knowing
the productivity draw. The second is closer to the present model, as it builds
on Melitz (2003) with a continuous investment possibility in a dynamic frame-
work. They however concentrate on dierent questions and make a strong
assumption about the functional form of the technology, which makes the
returns of process innovation proportional to rm prots. This is a special
case of my - in this respect - more general formulation, which prevents them
to obtain similar results on aggregate R&D intensity, on the size distribution
of rms or on the mass of consumed varieties.
In section 2, I present a closed economy version of the model to explain
the basic mechanisms at stake. In section 3, I extend the model to two
symmetric countries and examine the consequences of trade liberalisation for
rm level and aggregate spending in process innovation. Section 4 shows how
the model can be used to gain insight in the three aforementioned puzzles
and section 5 concludes.
4
Table 7 in Bustos (2007) suggests that among the group of initial exporters, the largest
raise their spending in technology faster than others.
4
2 The closed economy
2.1 Demand
The representative consumer has a C.E.S. utility function over a continuum
of varieties:
U =
__

q()
1

d
_
1
(1)
where the set represents all available varieties, q() stands for the consump-
tion of variety and for the elasticity of substitution between varieties,
assumed to be strictly greater than one. The maximisation problem of the
consumer yields the following demand function for a variety :
q() =
_
p()
P
_

Q (2)
where Q is an index of consumption Q U and P the ideal price index, i.e.
the price of bundle Q, dened as:
P =
__

p()
1
d
_ 1
1
(3)
The consumers income consists exclusively of the proceeds of his labour,
paid at a wage normalised to one. Labour supply L is inelastic, and is
an index of the size of the economy. The aggregate budget constraint is
therefore:
PQ = L (4)
2.2 Production
There is a continuum of rms, each producing a dierent variety with a
production technology using exclusively labour. Firms are heterogeneous
with respect to a productivity parameter z > 0, drawn from a continuous
distribution G(z) with support (0, Z] where Z . A rm drawing a large
z has an advantage in the sense that it can, other things equal, produce
with lower marginal costs. Upon learning its productivity parameter, the
rm decides how much to invest in process innovation (i) in order to reduce
its marginal costs. The production function of a rm having drawn z is as
follows:
5
y = zlt(i)
1
1
(5)
where l is the amount of labour used for production and the function
t(i)
1
1
is the investment technology, linking the amount invested in process
innovation i to its impact on marginal costs
5
. I assume that the function
t(i), dened on the positive reals, has the following properties:
Assumption 1 t

(i) > 0, t

(i) < 0, lim

i
t

(i) = 0 and lim

i0
t

(i) =
The last assumption is made to ensure that all producing rms invest a
positive amount in process innovation, which simplies the analysis
6
. This
does not seem implausible if one takes a broader view of this investment i
as any type of cost increasing the productivity of labour such as giving some
thoughts about the organisation of production.
This is in a sense the opposite assumption to that made in models where
rms choose between discrete technology choices. Bustos (2005) among oth-
ers assumes that the xed costs of investing in the high technology are so
high that only the most productive among exporting rms do invest. This
is necessary due to the assumption of two discrete technologies in order to
generate the result that trade liberalisation favours investment by exporting
rms, but is not required in the present setup with continuous decision.
2.2.1 Timing
The timing of the model is as follows. In a rst stage, there is an unbounded
mass of entrepreneurs, who decide whether they want to enter the market or
not. As in Melitz (2003), entering the market means paying a labour sunk
cost f
e
in order to obtain a draw of the parameter z. I add here a second
stage in which the rm decides how much to invest. In a third stage, the
rm sets its price and decides how much to produce.
This timing is realistic, since the investment decision is usually made
before the employment decision, and has been chosen for clarity of exposition.
However, a simultaneous investment and production decision would yield the
same results.
Firms live for a single period, which is another dierence to Melitz (2003),
who considers the eects of exogenous death and endogenous entry of rms.
5
t(i) is taken to the power
1
1
for simplicity.
6
Having rms producing without investing would require to deal with an additional
cuto level for the investment status.
6
The model can be straightforwardly extended to a dynamic framework but
this only complicates the matter without adding any insight
7
.
2.2.2 The optimisation problem of the rm
In the third stage, the rm sets its optimal price given its investment decision.
Since there is a continuum of rms, there are no strategic interactions, and
each rm optimises given the market conditions summarised by the price
index P. As is well-known in monopolistic competition models, the optimal
pricing decision is a xed markup over marginal costs:
p(z) =

1
t(i)
1
1
z
(6)
Using this optimal price in the demand equation (2) yields:
q(z) =
_

1
t(i)
1
1
zP
_

Q (7)
By backward induction, in stage 2, the optimal choice of i should max-
imise prots, which, using (4), are given by:

d
(z) = A(zP)
1
t(i)L i f (8)
where A
1

_

1
_
1
. Choosing a high level of investment allows a rm to
charge a lower price and therefore to sell more, but comes at a cost. f is the
xed cost component of production, which is common to all producing rms.
The rst order condition for this problem is given by:
A(zP)
1
Lt

(i
d
) 1 = 0 (9)
where i
d
is the investment level solving the rst order condition for rm
z. Assumption 1 ensures the existence of a solution for any z [0, ).
The rst order condition (9) denes the optimal level of investment for
a rm with productivity z, which I will denote i
d
(z). It appears that rms
invest more (i) the higher the price index, (ii) the higher their own produc-
tivity z. For a given rm, a higher price index or a high productivity means
that it is relatively ecient in comparison to its competitors. The rm there-
fore sells higher quantities, which drives the returns of investment up. For a
7
Helpman et al. (2004) also use a one-period model for simplicity.
7
given P, totally dierentiating the F.O.C. with respect to i
d
and z allows to
compare the optimal investment of rms having drawn dierent z:
di
d
t

(i)
t

(i)

i=i
d
+ ( 1)
dz
z
= 0 (10)
where
t

(i)
t

(i)
is the sensitivity of optimal investment to a change in the
conditions faced by the rm. This establishes the rst important result:
Proposition 1 The optimal investment of a rm is increasing in its size.
The proof is as follows: from (10), it is immediate that a rm with a high
z will optimally invest more. It follows that t(i
d
(z)) is increasing in z, and
that, from (7), the size of a rm - whether dened as domestic sales or labour
employed - is increasing in z.
Lemma 1 The function i
d
: [0, ) [0, ) is bijective
This follows directly from Assumption 1 and (10).
Using the F.O.C., I rewrite the variable prots (V P
d
) - given by the
rst term in (8) and dened as the sales minus the costs of labour used for
production - as:
V P
d
(z) =
t(i
d
(z))
t

(i
d
(z))

i
d
(z)
(i
d
(z))
(11)
where (i)
it

(i)
t(i)
is the elasticity of t(i). V P
d
(z) is increasing in z from
the concavity of t(i) and (10). It is useful at this stage to note that, by
construction of the model, the sales of a rm (s
d
(z)) are equal to:
s
d
(z) = V P
d
(z) =
t(i
d
(z))
t

(i
d
(z))
(12)
I impose some additional regularity conditions on (i) to make sure that
very productive rms make positive prots (i), and to simplify the interpre-
tation (ii).
Assumption 2 .
(i) (i) < 1 for small and for all i
(ii) (i) is monotonic over the whole range of i and bounded away from
zero.
8
2.3 The cuto productivity level
I dene z

as the cuto level of z for which, given the optimal investment

decision i
d
(z

), the rm breaks even when it produces, i.e. makes zero prots

given its optimal investment decision. Using (11):
t(i
d
(z

))
t

(i
d
(z

))
i
d
(z

) f = 0 (13)
Lemma 2 .
1. Under Assumption 1, the optimal level of investment of the cuto rm
z

is uniquely determined, and is independent of the level of z

.
2. There exists a strictly positive and unique cuto level z

such that all

rms with z > z

make strictly positive prots, and all rms with z < z

decide to exit the market.

Proof. See Appendix
Part 1 of the lemma is a useful property, which allows to express i
d
(z

)
independently of z

. The intuition for this result is that the optimal decision

of a rm depends on its relative productivity compared to its competitors.
Therefore, the least productive producing rm bases its decision on its rank,
not on its absolute productivity level z

. Thus, its optimal investment level

is independent of its exogenous eciency draw z

. For convenience, I will

therefore dene: i

i
d
(z

).
I now turn to general the equilibrium eect of the model. It is convenient
to express the ideal price index P as a function of the cuto rm z

. From
(13):
P
1
=
f +i

ALt(i

)
z
1
(14)
Since i

is constant from Lemma 2, the price index is inversely propor-

tional to the cuto productivity level z

. This is qualitatively similar to the

original Melitz (2003) model, and greatly simplies the welfare analysis in
the open economy case, which will only depend on the change in z

.
Two additional conditions are required to close the model. First, there
is free entry of entrepreneurs in the rst stage. An equilibrium therefore
requires that the sunk cost of entry be equal to the expected prots:
_
Z
z

d
(z)dG(z) = f
e
(15)
9
Second, the labour market must be in equilibrium:
L = M
___
Z
z

( 1)
t(i
d
(z))
t

(i
d
(z))
+i
d
(z) +fdG(z)
_
+f
e
_
(16)
where M is the mass of entrepreneurs paying the sunk entry cost f
e
.
The square bracket summarises the labour used for production purposes, for
investment and for the payment of xed and sunk costs.
3 The open economy
3.1 The setup
I now turn to the open economy version of the model, and assume that the
world consists of two symmetric countries, Home and Foreign. As in Melitz
(2003), exporting rms face two kinds of additional costs: iceberg trade
costs and xed costs of exporting. I dene iceberg trade costs 0 < < 1
as the fraction of goods that arrive at destination per unit shipped. The
xed costs of exporting f
x
, paid in units of labour, can be thought of as the
cost of establishing a brand on a foreign market, knowing a business law,
a culture. A Home rm which exports to the foreign market chooses the
following optimal pricing rule:
p
F
(z) =

1
t(i)
1
1
z
=
p
H
(z)

(17)
where the subscripts F and H denote Foreign and Home. The rm charges
the same markup as on its home market, due to identical preferences, but the
variable costs are higher, so that the c.i.f. price charged in a foreign country
is higher. Given the optimal price, and using the symmetry assumption
between the two countries, the sales of a rm on the foreign market are given
by:
q
F
(z) = q
H
(z)

(18)
Due to the higher price charged for exports, a Home rm sells less in Foreign
than at Home. The higher the price elasticity of demand, the higher this
eect. If it decides to export, a rm z faces the following maximisation
problem:
max
i

x
(z) = p
H
(z)q
H
(z) +p
F
(z)q
F
(z)
t(i)
1
1
z
(q
H
(z) +q
F
(z)) i f f
x
(19)
10
Plugging the optimal prices and quantities in the above problem, the
prots of an exporting rm can be rewritten as:

x
(z) = (1 +
1
)A(zP)
1
t(i)L (i +f
x
+f) (20)
And the the rst order condition for optimal investment if a rm export
i
x
is given by:
(1 +
1
)A(zP)
1
t

(i
x
)L 1 = 0 (21)
which denes a function i
x
(z) as the optimal investment decision of a rm
with productivity z if it decides to export. The optimal investment level of a
rm having drawn z is higher if it exports than if it does not. This is due to
the fact that an exporting rm sells more than an identical rm which would
only produce for the domestic market. This is therefore more protable to
save on the variable costs by investing in xed costs. This result is conform
to that of Bustos (2005) or Navas and Sala (2007).
Plugging (21) into (20) and rearranging allows to derive the global vari-
able prots (V P
x
) and sales (s
x
) of exporting rms:
s
x
(z) = V P
x
(z) =
t(i
x
(z))
t

(i
x
(z))
(22)
A rm will decide to export if it makes higher prots by exporting than
by producing only for its domestic market. In contrast to Melitz (2003) and
the subsequent literature, the decision to export is here not taken indepen-
dently of domestic considerations, because it inuences the optimal level of
investment, which in turn aects domestic prots. A rm having drawn z will
therefore export if the dierence between the prots it makes when exporting
and when not is positive:
A(zP)
1
L
_
(1 +
1
)t(i
x
(z)) t(i
d
(z))

i
x
(z) f
x
+i
d
(z) 0 (23)
where i
d
(z) and i
x
(z) respectively denote the optimal investment decision
of a rm z when it decides not to export, and when it decides to export.
Proposition 2 For f
x
suciently high, there exists a unique cuto rm
z

x
> z

which is indierent between exporting and producing only for its

domestic market. Firms having drawn a z above this cuto export, while
rms having drawn a lower z do not. The rm z

x
invests discretely more
than the most productive non-exporting rm.
11
Proof. See Appendix
There are two main dierences with the literature. First, the condition
for coexistence of non-exporting and of exporting rms is stronger than in the
standard Melitz (2003) framework, in the sense that f
x
should be suciently
higher than f. This is due to the fact that when deciding to export, a rm
scales up its investment and therefore its revenues on the domestic market at
the same time. This makes it more protable to export than in the standard
Melitz framework, and requires higher xed costs of exporting in order to
ensure that some producing rms do not export. Second, there is a discrete
jump in optimal investment at the cuto export level. This can not be
replicated by static discrete technology models, but goes in the direction
of Costantini and Melitz (2007), who argue that following an unanticipated
trade liberalisation, rms will simultaneously invest and enter the export
market. I therefore obtain a similar insight on this account in the present
static model as in dynamic frameworks, which are less tractable.
3.2 Trade liberalisation
In the following, I examine the eect of a decrease in the variable costs of
exports on the level of investment of exporting and non-exporting rms. A
decrease in the transport costs has an eect on the price index P and therefore
on the domestic cuto level z

, which should be taken into account. For this,

I use the condition that expected prots are equal to the xed entry costs:
E() =
_
z

x
z

d
(z)dG(z) +
_
Z
z

x
(z)dG(z) = f
e
(24)
I rewrite this condition using (8) and (20):
f
e
=
_
z

x
z

AP
1
Lz
1
t(i
d
(z)) i
d
(z) fdG(z)
+
_
Z
z

x
(1 +
1
)AP
1
Lz
1
t(i
x
(z)) i
x
(z) f f
x
dG(z) (25)
An increase in has a direct positive impact on the prot level of export-
ing rms, and tends to raise expected prots. The cuto z

therefore has to
increase in order for the expected prots to remain constant
8
. This decreases
8
The same mechanism as in Melitz (2003) is at stake here. The drop in the price index
increases the real wages and drives the least productive rms out of the market.
12
the price index from (14), and increases welfare, as in Melitz (2003). Follow-
ing a marginal change in , the envelope theorem states that the subsequent
change in the level of investment of all rms has a second order eect on
expected prots, and can be neglected. The entry of new rms on the export
market also has negligible eects on the expected prots, since these rms
are indierent between exporting or not.
The percentage change in the domestic cuto level is higher the larger
the proportional size of the exporting sector. Indeed, if most rms export,
a change in the variable costs of exporting has a large positive impact on
the expected prots, and the corresponding adjustment of z

must be high.
This, and the eect of trade liberalisation on the optimal investment of each
rm is summarized in the following proposition:
Proposition 3 .
1. A marginal decrease in variable trade costs raises the domestic cuto
level z

and therefore induces a selection eect.

2. A marginal decrease in variable trade costs decreases the optimal in-
vestment level of all rms that remain non-exporters.
3. A marginal decrease in variable trade costs induces an increase in the
investment of exporting rms.
Proof. See Appendix
Two factors play a role in these results. First, the drop in the price index
makes it more dicult for all rms to sell on a given market. This mechani-
cally reduces the incentives to invest, and accounts for the eect on domestic
rms. For exporting rms however, the decrease in the costs of exporting
allows to sell more on the export market. This second eect dominates the
drop in the price index, and raises their incentives to invest. The above
proposition constitutes a major dierence with the models in which the in-
vestment decision is discrete. In these frameworks, domestic rms would
continue production with the low technology, while very productive rms,
which already produce with the high technology would not invest more
9
.
9
This last fact especially is at odds with empirical evidence. Bustos (2007) shows that
among the group of initial Argentinean exporters in 1992, spending in technology has been
increased by trade liberalisation with Brazil, the more so for the largest exporters.
13
I now turn to the evolution of the cuto export level z

x
following a
marginal change in . This rm is by denition indierent between exporting
or not. From (23):
A(z

x
P)
1
L
_
(1 +
1
)t(i
x
(z

x
)) t(i
d
(z

x
))

i
x
(z

x
) f
x
+i
d
(z

x
) = 0 (26)
Using the envelope theorem, changes in i
d
(z

x
) and i
x
(z

x
) only have second
order eects on the above equation, which is the dierence between the prot
levels of exporting and of non-exporting rms. A marginal rise in has a
direct positive eect on the left hand side of the above equation, because
lower trade costs make it more protable to export relative to not exporting.
It also has an indirect negative eect through the implied decrease in the
price index P, which has a larger absolute impact for an exporting than for
a non-exporting rm. As shown in Appendix, the direct eect dominates
and a marginal trade liberalisation has the same impact on the export cuto
level as in Melitz (2003).
Proposition 4 A small reduction in the variable costs of trade decreases the
export cuto level z

x
, and raises the proportion of exporting rms.
Proof. See Appendix
3.3 Innovation intensity at the rm level
I now turn to the eects of trade liberalisation on the innovation intensity at
the rm level, which is dened as the ratio of spending on innovation divided
by sales. From the previous analysis, a decrease in the iceberg costs raises
optimal investment of exporting rms while decreasing that of non exporting
rms. This is however insucient to draw any conclusion about the change
in the innovation intensity of dierent rms.
The innovation intensity () for domestic and exporting rms is given by:

k
(z)
i
k
(z)
s
k
(z)
=
1

(i
k
(z)) for k {d, x} (27)
where the equality follows from (12) and (22). Therelationship between inno-
vation intensity and size of a rm depends on the elasticity of the innovation
technology. If

(i) > 0(< 0), the innovation intensity is increasing (decreas-

ing) in size while it is constant if

(i) = 0, which is a Cobb Douglas case.

A number of empirical studies have examined the relationship between inno-
vation intensity (measured as R&D spending per worker) and its size or its
14
export status. Bustos (2007)
10
or Bernard and Jensen (1995) show that big-
ger, exporting rms have a higher investment intensity, while others such as
Aw et al. (2007) nd the opposite result. Other studies such as Cohen et al.
(1987) and Cohen and Klepper (1996) point to the diculty of establishing a
clear link between R&D intensity and rm size across industries, suggesting
that this relationship may dier across industries. As the following results
show, the derivative of (i) plays a central role in the analysis.
Proposition 5 .
if

(i) = 0, a marginal decrease in the costs of trade has no impact on

the innovation intensity at the rm level.
if

(i) > (<)0, a marginal decrease in the costs of trade raises (de-
creases) the skill intensity of exporting rms while decreasing (raising)
that of non-exporting rms.
Proof. The proof follows trivially from Proposition 3.
Following trade liberalisation, exporting rms increase their global sales
and therefore raise their innovation level. If the technology t is such that
large rms have a higher innovation intensity (

(i) > 0), exporting rms raise

their innovation intensity following liberalisation. The contrary happens for
non-exporting rms, who reduce their sales and therefore their innovation
intensity. The results are reversed if

(i) < 0.
3.4 Aggregate innovation intensity
Since both exporting and non-exporting rms change their innovation inten-
sity in dierent directions following a reduction in trade costs, it is a priori
unclear how the aggregate innovation intensity changes.
For the interpretation of the results in this and the following sections, it
is useful to dene the relative sensitivity of investment to external conditions
as E(i):
E(i)
t

(i)
2
t

(i)t(i)
(28)
Indeed, as seen in (10),
t

(i)
t

(i)
can be interpreted as the sensitivity of optimal
investment by a rm investing i. The ratio of this sensitivity to the vari-
able prots, which is a measure of the relative sensitivity of investment, is
10
Tables 9 and 10
15

(i)
2
t

(i)t(i)
. The higher the E, the higher will be the proportional adjustment
of investment by a rm to changes in external conditions. The relationship
between E(i) and the investment intensity of a rm is given by the following
lemma:
Lemma 3 Under Assumptions 1 and 2,

(i) and E

(i) have the same sign.

Proof. See Appendix
This states that if large rms are relatively investment intensive (i.e. if
the technology is such that the optimal investment intenstity rises with the
investment level:

(i) > 0), their investment will be relatively sensitive to a

change in market conditions.
Aggregate innovation intensity (R) is dened as the ratio of aggregate
innovation to aggregate sales and is given by:
R
_
z

x
z

i
d
(z)dG(z) +
_
Z
z

x
i
x
(z)dG(z)
_
z

x
z

_
z
z

_
1
t(i
d
(z))
t(i

)
(i

+f)dG(z) +
_
Z
z

x
(1 +
1
)
_
z
z

_
1
t(i
x
(z))
t(i

)
(i

+f)dG(z)
(29)
A decrease in trade costs has two types of eects on the aggregate innova-
tion intensity, which I will denote as Eects B and C. Eect B summarises
the impact of rms changing their export or domestic status following a re-
duction in , i.e. rms entering the export market or stopping production.
These are represented by the change in the cuto level z

and z

x
. Eect C
denotes the impact of the change in the innovation intensity of all other rms
following a decrease in trade costs. This second eect is to my knowledge
new in the literature and captures the adjustment in skill intensity of all
producing rms. As it concerns all rms, and not only cuto rms, it may
be potentially more important. The following Proposition summarises the
impact of Eect C on the aggregate innovation intensity R in the economy.
Proposition 6 .
if

(i) = 0, Eect C has no impact on the aggregate innovation inten-

sity, which remains constant.
if

(i) > (<)0, Eect C raises (decreases) the aggregate innovation

intensity.
16
Proof. See Appendix
Proposition 6 states that if

(i) > 0, the increae in innovation inten-

sity by exporting rms dominates the reduction in innovation intensity by
non-exporting rms. The proof in Appendix is instructive in order to un-
derstand the intuition for this result. As stated in Lemma 3, E

(i) has the

same sign as

(i). If E

(i) > 0, large rms react proportionately more to a

change in market conditions than small rms and the rise in innovation in-
tensity by exporting rms dominates the drop in the innovation intensity of
non-exporters. Trade liberalisation therefore raises the aggregate innovation
intensity if

(i) > 0. The reverse argument applies for the case:

(i) < 0.
4 The Puzzles
Thanks to its rich structure, the model can be used to study a number of
recent empirical puzzles in the literature on trade and heterogeneous rms.
These are: (i) the negative relationship between rm size and Tobins Q
(Nocke and Yeaple (2006)) (ii) the change in the skewness of the size dis-
tribution of rms when trade costs decrease (Nocke and Yeaple (2006)) (iii)
the increase in the mass of consumed varieties following trade liberalisation
(Baldwin and Forslid (2006)).
4.1 Tobins Q and rm size
Nocke and Yeaple (2006) nd empirical evidence that the Tobins Q of a rm
is negatively related to its size, and argue that the introduction of capital
in the Melitz (2003) model would predict the opposite relationship. For this
statement, they consider an extended version of the Melitz (2003) model
where xed costs of production are paid in terms of capital, and where the
production function is Cobb-Douglas with capital and labour. Without xed
costs, all rms would use the same fraction of capital in production, and the
value of capital (the book value) would be a constant fraction of variable
prots (the market value in a static framework) for all rms. The xed costs
paid in terms of capital however account for a higher share of the market
value for small rms than for large rms, and therefore yields a Tobins Q
that is increasing with size. This, they argue, runs counter to empirical
evidence.
It is straightforward to introduce capital in the present setup under the
asssumption that it is held by foreigners, and available to all rms in the
17
economy at an exogenous price r. I assume that the xed costs and the costs
of innovation (f + i) are paid in terms of capital so as to be in line with
the interpretation of Nocke and Yeaple (2006), but abstract from the Cobb
Douglas production function
11
. The main dierence between the present
model and traditional heterogeneous rm models is that larger rms invest
more in productivity. This is precisely the mechanism that allows me to
reverse the relationship between size and Tobins Q as I will show next.
A rm with productivity z uses the following amounts of capital if it
respectively does not and does export:
K
d
(z) = i
d
(z) +f (30)
K
x
(z) = i
x
(z) +f +f
x
(31)
From (11) and (22), the Tobins Q, which is equal to variable prots over
capital
12
:
T
d
(z) =
t(i
d
(z))
t

(i
d
(z))(i
d
(z) +f)
(32)
T
x
(z) =
t(i
x
(z))
t

(i
x
(z))(i
x
(z) +f +f
x
)
(33)
Proposition 7 .
If

(i) 0 the Tobins Q is decreasing in rm size conditional on the

export status.
If

(i) > 0, the Tobins Q is increasing in size for small rms, and
decreasing in size for larger rms.
The smallest exporting rm has a lower Tobins Q than the largest non-
exporting rms.
Proof. See Appendix
11
Introducing a Cobb Douglas production function would not alter the qualitative re-
sults.
12
To be precise, the Tobins Q is equal to variable prots over capital payment:rK. Due
to the price of capital however, variable prots are equal to r times the expression in (11)
and (22), so that r does not matter.
18
The intuition for this result is as follows. If

(i) 0, the technology

t is such that i rises less than proportionately with rm variable prots so
that the ratio of variable prots to capital tends to increase with size due
to this property. In addition, the xed costs f and f
x
represent a lower
proportion of variable prots the larger the rm thereby strengthening the
positive eect of size on the Tobins Q. In this case, both eects go in the
same direction and larger rms have a larger Tobins Q conditional on their
export status. If

(i) > 0 on the other hand, the technology t is such

that large rms employ proportionately more capital, driving the Tobins
Q of larger rms down. This goes in the opposite direction to the eect
of the xed costs, and I show in Appendix that the relationship between
Tobins Q and size is inverted U-shaped: for small rms, the eect of the
xed costs dominates while for suciently large rms, the technology eect
dominates and generates a negative correlation between size and Tobins Q.
This can account for the puzzle mentioned in Nocke and Yeaple (2006) that
the Tobins Q decreases with size. Furthermore, there is a discontinuity in
the relationship between size and Tobins Q at the cuto export level. For the
cuto exporting rm, exporting is associated with large xed and investment
costs but a limited increase in variable prots, so that its ratio of variable
prots to capital is lower than if it were purely domestic. This provides an
additional rationale for which Tobins Q and rm size may be negatively
correlated.
4.2 The distribution of rm size
Nocke and Yeaple (2006) empirically nd that, for U.S. rms, trade liber-
alisation has reduced the skewness of the distribution of the logarithm of
domestic sales. In other words, the relative size dierential between two
given rms appears to have decreased due to trade liberalisation.
In the traditional Melitz (2003) model, a decrease in trade costs aects
domestic sales through a change in the price index, which has the same pro-
portional eect on the domestic sales of all rms. In the present model,
I show that the eect of a reduction in trade costs on the size distribu-
tion is non monotonic: depending on

(i), the size dierential between two

non-exporting rms rises (decreases) while that between two exporting rms
decreases (rises). This does not necessarily run counter to the evidence in
Nocke and Yeaple (2006), since they do not allow for non-monotonicity in the
reaction to trade liberalisation. However, the dierence in log size between
the group of exporters and of non-exporters should increase.
19
Domestic sales (s) of a rm with productivity z are given by:
s
dd
(z) = A(zP)
1
t(i
d
(z))L for z < z

x
(34)
s
dx
(z) = A(zP)
1
t(i
x
(z))L for z z

x
(35)
where s
dd
and s
dx
respectively stand for the domestic sales of a non-
exporting and of an exporting rm.
Using the equation for the price index (14), I rewrite these quantities as:
s
dk
(z) = (f +i

)
t(i
k
(z))
t(i

)
_
z
z

_
1
for k {d, x} (36)
The percentage change in domestic sales for non-exporting rms following
a marginal trade liberalisation is given by:
dln(s
dd
(z))
d
=
dz

d
1
z

[E(i
d
(z)) + 1] (37)
There are two eects that inuence the domestic sales of non-exporting
rms following trade liberalisation. First, there is a direct eect of the price
index on sales, as shown by 1 in the bracket. Trade liberalisation increases the
average productivity of competitors, thereby decreasing the price index and
the domestic sales of all non-exporting rms. Second, the reduction in sales
drives the incentives to invest down, as shown by the rst part of the bracket.
This further reduces domestic sales. If

(i) = 0 this implies by Lemma 3

that E(i) is constant for all i. The same result as in the Melitz (2003)
model therefore holds, and the log of domestic sales of all non-exporting
rms changes by exactly the same amount. In this case, the change in optimal
investment by non-exporting rms of all sizes is such that the quantity they
sell decreases by the same proportion. However, if

(i) < 0, the drop in

sales is more pronounced for the smallest of the non-exporting rms, while
the larger non-exporting rms see their sales decrease by a lesser fraction.
This is due to the investment technology, which is such that small rms
are proportionately more reactive in their investment decision than larger
rms. Under this assumption, the size dierential between non-exporting
rms increases.

(i) > 0 would yield opposite consequences.

For exporting rms:
dln(s
dx
(z))
d
= ( 1)
_

dz

d
1
z

+
_

2
1 +
1

dz

d
1
z

_
E(i
x
(z))
_
(38)
20
As for domestic rms, the decrease in the price index P directly aects
exporting rms and makes it more dicult for them to sell on the domes-
tic market. This is captured by the rst term in bracket in (38). Again,
the direct and the indirect eects mentioned above play a role here. The
increase in the price index also aects exporting rms and makes it more
dicult for them to sell on the domestic market. However, exporting rms
also benet from a decrease in the transport costs on their export market,
which raises their global sales, and therefore their investment and produc-
tivity (from Proposition 3). Which of the two eects dominates is unclear,
so that the sign of the change in domestic sales remains undetermined for
exporting rms. However, the group of exporters should see its domestic
sales decrease proportionately less than that of non-exporting rms.
The elasticity of the technology function plays again a central role in
the determination of the skewness of the sales distribution. A constant E(i)
yields the same proportional change in domestic sales by all exporting rms,
although it is worth noting that this change is not equal to that of domestic
rms. If E

(i) < 0, size dierentials between exporting rms become smaller,

since the smaller exporters raise their investment proportionally more than
larger exporters. A decreasing E(i) has the opposite eect.
These eects are summarised in the following Proposition:
Proposition 8 The eect of trade liberalisation on the size distribution of
rms depends on the investment technology t(i).
If

(i) = 0, the domestic sales of all non-exporting rms decrease by

the same proportion. Those of all exporting rms also change by a
constant proportion, albeit dierent from that of non exporting rms.
If

(i) < 0(> 0), the dierence between the log of domestic sales of two
given non-exporters decreases (increases), while that between two given
exporters increases (decreases).
As in Nocke and Yeaple (2006), the present paper can explain the fact that
dierent rms reduce their domestic sales by dierent proportions following
trade liberalisation. While they predict a decrease between the dierences in
the log size of two given rms, the present model suggests a non monotonic
change, which however does not contradict their empirical ecidence as they
do not allow for non-monotonicity.
21
4.3 Mass of consumed varieties
Traditional models of monopolistic competition built on Krugman (1979)
emphasise the increase in the number of available varieties as one of the
main gains from trade, a result which has been supported by a number of
empirical studies, such as Feenstra (2006) or Broda and Weinstein (2006).
In Melitz (2003) however, the number of consumed varieties decreases with
trade liberalisation under the usual assumption that productivity draws are
Pareto distributed and that f
x
> f. I here show how the present framework
can account for this puzzle.
The labour market equilibrium requires that in each country:
L = M
__
z

x
z

A( 1)t(i
d
(z))z
1
P
1
L +i
d
(z) +fdG(z)
_
+M
__
Z
z

x
A(1 +
1
)( 1)t(i
x
(z))z
1
P
1
L +i
x
(z) +f +f
x
dG(z)
_
+Mf
e
(39)
where M is the mass of entrepreneurs in a country who decide to pay
the sunk cost in order to obtain a draw of productivity. The rst part of
the right hand side is the labour used by domestic rms for production and
xed costs purposes. The second bracket is the labour used by exporting
rms, and Mf
e
is the labour used for the payment of the sunk costs by all
entrerpreneurs who enter the market. This equation determines M.
The mass of consumed varieties (N) is given by:
N = M(1 G(z

) + 1 G(z

x
)) (40)
which is the mass of entrerpreneurs entering the market in a country, times
the fraction from which a consumer in a given country can buy products (i.e.
home entrepreneurs who decide to produce and foreign entrepreneurs who
decide to export). Trade liberalisation has dierent eects on the right hand
side of (39), which I decompose into two groups: (i) the eect of the cuto
rms, and (ii) the eect of all other rms.
(i) The increase in the domestic cuto level z

and the decrease in the

export cuto z

x
have a direct eect on the fraction of rms that serve a given
market. They moreover have an eect on M, the mass of entrepreneurs pay-
ing the sunk cost. Indeed, domestic rms exiting the market release labour,
which tends to increase M from (39). On the other hand, new exporting rms
will raise their demand for labour, and tend to decrease M. These combined
eects of the cuto rms are qualitatively similar to those of Melitz (2003).
22
Their quantitative eect depends, among others, on the distribution function
G(z) of productivity draws. In Melitz (2003), under a Pareto distribution,
these cuto eects tend to decrease the number of consumed varieties.
(ii) I now turn to the eects of all non-cuto rms on M. From the
labour market condition (39), if their combined demand for labour increased
(decreased), this would push M down (up). In Melitz (2003), the aggregate
labour used by all rms that are not at the cuto level remains constant
when trade liberalisation occurs. This is an important property of this model,
which is such that the eect of the cuto rms determines the change in the
mass of consumed varieties. The intuition is as follows. First, the decrease
in the price index following liberalisation reduces the demand for labour for
domestic sales. The size of this eect is determined by the relative weight
of exporters in the aggregate variable prots. The higher this proportion
the higher the eect of a marginal trade liberalisation on the price eect
since many exporters raise their production on the domestic market, and the
higher the reduction in the demand for labour for domestic sales. Second,
exporting rms sell more on the export market, and increase their demand
for labour for this reason. This eect also depends on the exporters weight
in aggregate prots, and the model is so constructed that both eects exacly
cancel out.
In the present model, however, this will not be necessarily the case. As
proved in Appendix, the change in aggregate demand for labour by all non-
cuto rms depends on

(i). If

(i) = 0, the intuition of the Melitz (2003)

model holds, because the proportionality between change in labour demand
and change in variable prots is preserved. If

(i) < 0 however, exporting

rms raise their demand for labour proportionately less because they are less
sensitive. This releases resources and allows M to increase, pushing up the
mass of consumed varieties N. This provides an additional eect raising the
mass of consumed varieties, which is potentially important since it concerns
all rms and not only the cuto rms.
5 Conclusion
This paper has developed a Melitz (2003) type model of trade, in which,
after observing their eciency, rms invest in productivity improvements.
The investment decision is continuous, in the sense that each rm decides
how much to invest. This framework preserves all main qualitative results
of Melitz (2003), and provides additional insights in the investment decision
of heterogeneous rms. Indeed, I am able to replicate a number of well
23
established stylised facts, with weak assumptions for a well behaved problem.
Exporters in the model invest more than non-exporters, and raise investment
following trade liberalisation. Among the group of exprters, the biggest rms
invest more and also invest more following trade liberalisation. This last
empirical fact can not be replicated in models of discrete investment decision.
I also generate a number of testable implications. (i) Non-exporting rms
should scale down their investment following trade liberalisation. (ii) The
domestic sales of non-exporting rms should decrease proportionately more
than these of exporting rms
13
following trade liberalisation.
Depending on the properties of the innovation technology, I show how the
rm-level innovation intensity adapts following trade liberalisation. If the
technology is such that large rms innovate proportionately more, exporting
rms, who expand their production, increase their innovation intensity and
non-exporting rms decrease theirs. This same property of the technology
allows to provide a new micro-founded rationale and clear conclusions for the
eect of trade on aggregate R&D intensity.
The present model also addresses three puzzles that have arisen in the last
years: (i) the negative relationship between rm size and Tobins Q (Nocke
and Yeaple (2006)) (ii) the change in the skewness of the size distribution of
rms when trade costs decrease (Nocke and Yeaple (2006)) (iii) the increase
in the mass of consumed varieties following trade liberalisation (Baldwin
and Forslid (2006)). I show that the investment technology, and especially
the sensitivity of investment relative to rm size, plays a central role in
explaining them. These results cannot be obtained by the other existing
models of process innovation in the Melitz (2003) framework, either due to
the discrete investment decision
14
or to an assumption on the specic form
of the investment technology
15
. The importance of the properties of the
investment technology, which is arguably dierent across sectors, suggests
more caution for the interpretation of empirical results on the above puzzles,
which are usually investigated across sectors.
13
In some instances, the domestic sales of exporting rms should even increase.
14
Bustos (2005), Bustos (2007), Ederington and McCalman (2006) and others
15
Atkeson and Burstein (2007)
24
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26
Appendix
Proof of Lemma 2
Proof of part 1
In this section, I show that there is a unique i solving:
t(i)
t

(i)
i f = 0 (41)
For this, note that
t(0)
t

(0)
= 0 by Assumption 1. The left hand side of the above equation
is therefore equal to f for i = 0.
Dierentiating the left hand side with respect to i:

_
t(i)
t

(i)
i f
_
i
=
t

(i)t(i)
t

(i)
2
> 0 (42)
I now show that as i goes to innity, the left hand side will be positive, which is to
say that at least some rms will make non-negative prots in the economy.
The left hand side of (41) can be rewritten as:
t(i)
t

(i)
_
1
(i +f)t

(i)
t(i)
_
(43)
As i goes to innity,
t(i)
t

(i)
by Assumption 1. Moreover, lim
i
(i+f)t

(i)
t(i)
=
lim
i
(i), which is bounded away from 1. The square bracket above is therefore
bounded, and the whole expression therefore goes to innity.
This completes the proof that there exists a unique i so that there is a cuto rm that
makes zero prots. This is moreover independent of z

Proof of part 2
The proof of part 2 follows from part 1 and from Lemma 1.
Proof of Proposition 2
For clarity of exposition, I rewrite the condition for a rm z to export (23):
A(zP)
1
L(1 +
1
)t(i
x
(z)) i
x
(z) f f
x
. .

x
(i
x
(z))
A(zP)
1
Lt(i
d
(z)) +i
d
(z) +f
. .

d
(i
d
(z))
0
(44)
which requires that the dierence in prots between the two strategies (domestic&export
and domestic) be positive.
27
(i) A straightforward application of the envelope theorem shows that the derivative of
the left-hand side with respect to z is positive, since the eects of z on optimal investment
are of second order importance. This means that the higher the z, the larger the relative
prot of the export strategy.
(ii) For z = z

,
d
= 0, and
x
(i
x
(z

)) should be negative for the cuto rm z

not
to export. This obtains if f
x
is suciently high for any .
(iii) As z , if > 0, it is immediate from (44) that
x
(i
d
(z))
d
(i
d
(z)) .
Since by denition,
x
(i
x
(z)) >
x
(i
d
(z)), this implies that the dierence between the
prots of the export and non-export strategies goes to innity.
Combining (i), (ii) and (iii) shows Proposition 2
Proof of Proposition 3
Part 1: the selection eect
Plugging (14) into (25) and totally dierentiating yields:
z

=
_
Z
z

1
z
1
t(i
x
(z))dG(z)
_
z

x
z

z
1
t(i
d
(z))dG(z) +
_
Z
z

x
(1 +
1
)z
1
t(i
x
(z))dG(z)
=
X
S
(45)
Where X and S respectively denote total exports of a country, and global sales of
rms from this country (which, by the symmetry assumption is equivalent to total sales in
a country). To derive the above expression, the envelope theorem has been used, as well
as the indierence conditions of the z

and z

x
rms. It is clearly positive and shows that
trade liberalisation yields a selection eect by increasing z

.
Part 2: Change in optimal investment of non-exporting rms
For non-exporting rms, the rst order condition for optimal investment rearranged
with (14) is:
(i

+f)
_
z
z

_
1
t

(i
d
)
t(i

)
= 1 (46)
It is immediate that a change in impacts the optimal decision of non-exporting rms
only through the general equilibrium eect of a drop in the price index and therefore
an increase in z

(remember that from Lemma 2, i

remains constant). The rise in z

following trade liberalisation must incur a decrease in the optimal investment of a non-
exporting rm since t(i) is concave. This can be immediately seen by totally dierentiating
(46):
di
d
= ( 1)
t

(i
d
)
t

(i
d
)
dz

(47)
Plugging in (45) yields:
di
d
= ( 1)
t

(i
d
)
t

(i
d
)
X
S
d

(48)
28
Part 3: Change in optimal investment of exporting rms
For exporting rms, the rst order condition for optimal investment rearranged with
(14) is:
(1 +
1
)
_
z
z

_
1
(i

+f)
t

(i
x
)
t(i

)
= 1 (49)
Totally dierentiating the above equation and rearranging:
di
x
= ( 1)
_

1
1 +
1
d

+
dz

_
t

(i
x
)
t

(i
x
)
(50)
The square bracket shows the two eects of trade liberalisation: the rst term is the
direct eect that exporting rms can sell more on their export market, the second term
is the indirect general equilibrium eect of a smaller price index, which makes it more
dicult for these rms to sell.
Plugging in (45):
di
x
= ( 1)
d

_
X
S


1
1 +
1
_
t

(i
x
)
t

(i
x
)
(51)
As long as some rms do not export,
X
S
<

1
1+
1
. This shows that the direct eect
of a change in (the 1 in the bracket) dominates the general equilibrium eect for the
total sales of exporters (the ratio of total exports to total sales) and trade liberalisation
therefore raises the investment of exporting rms.
Proof of Proposition 4
To highlight the general equilibrium eects of a change in trade costs on the export cuto
level, I rewrite (26) using (14):
(f +i

)
t(i

)
_
z

x
z

_
1
_
(1 +
1
)t(i
x
(z

x
)) t(i
d
(z

x
))

i
x
(z

x
) f
x
+i
d
(z

x
) = 0 (52)
Totally dierentiating the above equation and using the envelope theorem yields:
dz

x
z

dz

+
d

(1 +
1
)t(i
x
(z

x
))
(1 +
1
)t(i
x
(z

x
)) t(i
d
(z

x
))
= 0 (53)
Using (45), this can be rewritten as:
dz

x
z

x
=
d

1
1 +
1
_
(1 +
1
)t(i
x
(z

x
))
(1 +
1
)t(i
x
(z

x
)) t(i
d
(z

x
))

X
S
_
(54)
The rst term in the square bracket above is larger than one, while
X
S
< 1. The right
hand side is therefore negative and trade liberalisation decreases the export cuto level
z

x
.
29
Proof of Lemma 3

(i) is equal to:

(i) =
t

(i)
t(i)
+i
t

(i)t(i) t

(i)
2
t(i)
2
=
_
t

(i)
t(i)
_
2
_
t(i)
t

(i)
+i
t

(i)t(i)
t

(i)
2
i
_
(55)

(i) has therefore the sign of the square bracket on the right hand side. From Assumptions
1 and 2 (and using lHopitals rule to show that
t

(i)t(i)
t

(i)
2
is bounded as i 0), the square
bracket is equal to zero if i 0. Furthermore:

_
t(i)
t

(i)
+i
t

(i)t(i)
t

(i)
2
i
_
i
= i

(i)t(i)
t

(i)
2
i
iE

(i) (56)

(i) and E

(i) therefore have the same sign.

Q.E.D.
Proof of Proposition 6
The aggregate R&D intensity in the economy is dened as the ratio of innovation spending
by all rms in a sector to total sales in that sector:
R
_
z

x
z

i
d
(z)dG(z) +
_
Z
z

x
i
x
(z)dG(z)
_
z

x
z

_
z
z

_
1
t(i
d
(z))
t(i

)
(i

+f)dG(z) +
_
Z
z

x
(1 +
1
)
_
z
z

_
1
t(i
x
(z))
t(i

)
(i

+f)dG(z)
(57)
Totally dierentiating the above equation requires to split up the problem in order
to keep track of the economic intuition. In order to simplify notation, I denote the nu-
merator of the above equation as u and the denominator as v. The total dierentiation
of the numerator and of the denominator can be decomposed into two parts: (i) Eect
B represents the impact of the cuto rms (z

and z

x
), which switch status (domestic
or exporting) following trade liberalisation. They correspond to the dierentiation of the
boundaries of the integrals in (29) and their eect will be summarised by the term B
u
for the numerator and B
v
for the denominator. (ii) Eect C stands for the impact of the
rms not switching status, of which the eect will be denoted C
u
and C
v
respectively for
the numerator and denominator. Therefore:
du = B
u
+C
u
(58)
dv = B
v
+C
v
(59)
and:
d
_
u
v
_
=
1
v
_
_
_
_
B
u
B
v
u
v
. .
Eect B
+C
u
C
v
u
v
. .
Eect C
_
_
_
_
(60)
The rst part of the bracket can therefore be interpreted as the eect of the cuto
rms changing status (the extensive margin) while the second part is the change in the
intensive margin of investment intensity for all rms.
30
Eect C
I rst turn to eect 2, which is the eect this paper concentrates on. Total dierentiation
of (29) using (48) and (51) yields:
C
u
= ( 1)
d

_
_
z

x
z

(i
d
(z))
t

(i
d
(z))
dG(z)
X
S
+
_
Z
z

x
t

(i
x
(z))
t

(i
x
(z))
dG(z)
_
X
S


1
1 +
1
_
_
(61)
and:
C
v
= ( 1)
d

_
_
z

x
z

(i
d
(z))
t

(i
d
(z))
dG(z)
X
S
+
_
Z
z

x
t

(i
x
(z))
t

(i
x
(z))
dG(z)
_
X
S


1
1 +
1
_
_
+ v
_
( 1)
d

X
S

dz

( 1)
_
(62)
The rst line on the right hand side of C
v
captures the eect on aggregate sales of
the change in innovation by all producing rms. The second line reects the between rm
reallocation of sales due to a change in trade costs, which, for a constant innovation level,
raises global sales of exporting rms and reduces those of purely domestic rms. The net
eect of this reallocation is however zero as can be seen by setting
dz

equal to its value

in (45)
Eect C can therefore be written as:
d

( 1)
_
1
u
v
_
_
_
z

x
z

(i
d
(z))
t

(i
d
(z))
dG(z)
X
S
+
_
Z
z

x
t

(i
x
(z))
t

(i
x
(z))
dG(z)
_
X
S


1
1 +
1
_
_
(63)
1
u
v
is positive since all rms make non-negative prots. Indeed,
v

is the average
variable prot of a rm, which is larger than average innovation spending (u) in order to
ensure that xed costs can still be paid without making negative prots. The sign of (63)
is therefore given by the sign of the square bracket.
From (11) and a similar equation for exporting rms, the ratio of exports to sales can
be rewritten as:
X
S
=

1
1 +
1
_
Z
z

x
t(i
x
(z))
t

(i
x
(z))
dG(z)
_
z

x
z

t(i
d
(z))
t

(i
d
(z))
dG(z) +
_
Z
z

x
t(i
x
(z))
t

(i
x
(z))
dG(z)
(64)
Using this expression, the square bracket in (63) is equal to:

1
1 +
1

_
_
_
z

x
z

(i
d
(z))
t

(i
d
(z))
dG(z)
_
z

x
z

t(i
d
(z))
t

(i
d
(z))
dG(z)

_
Z
z

x
t

(i
x
(z))
t

(i
x
(z))
dG(z)
_
Z
z

x
t(i
x
(z))
t

(i
x
(z))
dG(z)
_
_
(65)
where
=
_
Z
z

x
t(i
x
(z))
t

(i
x
(z))
dG(z)
_
z

x
z

t(i
d
(z))
t

(i
d
(z))
dG(z)
_
z

x
z

t(i
d
(z))
t

(i
d
(z))
dG(z) +
_
Z
z

x
t(i
x
(z))
t

(i
x
(z))
dG(z)
> 0 (66)
31
Dene:
t(i
d
(z))
t

(i
d
(z))
dG(z) d(z) (67)
t(i
x
(z))
t

(i
x
(z))
dG(z) d(z) (68)
Using the denition of E(i) and changing the measure of the integral with (67) and
(68):
_
z

x
z

(i
d
(z))
t

(i
d
(z))
dG(z)
_
z

x
z

t(i
d
(z))
t

(i
d
(z))
dG(z)
=
_
z

x
z

E(i
d
(z))d(z)
_
z

x
z

d(z)
(69)
_
Z
z

x
t

(i
x
(z))
t

(i
x
(z))
dG(z)
_
Z
z

x
t(i
x
(z))
t

(i
x
(z))
dG(z)
=
_
Z
z

x
E(i
x
(z))d(z)
_
Z
z

x
d(z)
(70)
Using this in (65) immediately shows that if E

(i) = 0, the whole term in (65) is

zero and Eect C has no impact on the aggregate innovation intensity. I now expose
the argument for the case:

(i) > 0, which by Lemma 3 implies E

(i) > 0. In this case

(remember that i
d
(z) and i
x
(z) are both strictly increasing in z):
_
z

x
z

E(i
d
(z))d(z)
_
z

x
z

d(z)
< E(i
d
(z

x
)) (71)
_
Z
z

x
E(i
x
(z))d(z)
_
Z
z

x
d(z)
> E(i
x
(z

x
)) (72)
Moreover, if E

(i) > 0, E(i

x
(z

x
)) > E(i
d
(z

x
)). Therefore, if

(i) > 0, (65) is positive

and Eect C raises the aggregate R&D intensity. If

(i) < 0 on the other hand, all

inequality signs above are reversed and the intensive margin reduces aggregate innovation
intensity.
This proves Proposition 6
Eect B (cuto rms)
For completeness, I now turn to Eect B, i.e. the impact of the cuto domestic rms
stopping production and investment, and of cuto exporting rms starting to export and
raising their innovation investment.
B
u
=
dz

g(z

)z

+
dz

x
z

x
(i
d
(z

x
) i
x
(z

x
))g(z

x
)z

x
(73)
B
v
=
dz

g(z

)z

(i

+f)
dz

x
z

x
_
z

x
z

_
1
z

x
g(z

x
)
(i

+f)
t(i

)
_
(1 +
1
)t(i
x
(z

x
)) t(i
d
(z

x
))

(74)
where
dz

and
dz

x
z

x
are given by (45) and (54).
32
The whole Eect 1 is therefore given by:
B
u
B
v
u
v
=
dz

g(z

)z

_
i

_
1
u
v
_
f
u
v
_
(75)
+
dz

x
z

x
g(z

x
)z

x
_
(i
x
(z

x
) i
d
(z

x
))
_
u
v
1
_
+f
x

u
v
_
(76)
The sign of the above expression is undetermined and depends among others on the
density function. The rst line of the right hand side represents the eect of the domestic
cuto rms dropping out of the market. They tend to decrease aggregate investment as
well as aggregate sales and therefore have an ambiguous eect for the innovation intensity.
The second line is the eect of new rms entering the export market. They raise their
spending on innovation as well as their sales, and therefore also have an ambiguous eect
on the aggregate innovation intensity.
Proof of Proposition 7
I rst concentrate on purely domestic rms. The Tobins Q of a rm investing i is given
by (33):
T(i) =
1
(i) +f
t

(i)
t(i)
(77)
Therefore, T

(i) is of the sign of:

T

(i)
_

(i) f
_
t

(i)
t(i)
_
2
_
1 +
1
E(i)
_
_
(78)
The second term in bracket is always negative so that if

(i) 0, T

(i) is positive. Using

that:

(i) =
t

(i)
t(i)
i
_
t

(i)
t(i)
_
2
_
1 +
1
E(i)
_
(79)
T

(i) can be rewritten as:

T

(i) =
_
t

(i)
t(i)
(i +f)
_
t

(i)
t(i)
_
2
_
1 +
1
E(i)
_
_
(80)
so that lim
i

(i) = lim
i
T

(i). For the case that

(i) > 0, this shows that for

a suciently high i, T

(i) < 0. The Tobins Q then decreases with investment (and

therefore size). All results up to this point can be straightforwardly extended to the case
of exporting rms by replacing f by f + f
x
. For i = i

, which is the smallest producing

rm, it is immediate from (13) that:
T

(i

) =
t

(i

)
t(i

)
1
E(i

)
> 0 (81)
The Tobins Q is therefore increasing in i, and in size, for the smallest producing rms.
From the indierence condition of the cuto exporting rm (26):
t(i
x
(z

x
))
t

(i
x
(z))
i
x
(z

x
) f
x
f =
t(i
d
(z

x
))
t

(i
d
(z

x
))
f i
d
(z

x
) (82)
33
Using the denition of the Tobins Q in (32) and (33), this can be rewritten as:
T
x
(z

x
) 1
T
d
(z

x
)
=
i
d
(z

x
) +f
i
x
(z

x
) +f +f
x
(83)
Since the Tobins Q is larger than one for the cuto exporting rm, it immediately
follows that T
x
(z

x
) < T
d
(z

x
). This shows that the smallest exporting rm has a lower
Tobins Q than the largest non-exporting rms.
Mass of consumed varieties
Plugging the free entry equation (25) in the labour market condition (39) yields:
L = M
_
_
z

x
z

t(i
d
(z))Az
1
P
1
LdG(z) +
_
Z
z

x
(1 +
1
)t(i
x
(z))Az
1
P
1
LdG(z)
_
(84)
Using the price index equation (14):
L = M
f +i

t(i

)
z
1
_
_
z

x
z

t(i
d
(z))z
1
dG(z) + (1 +
1
)
_
Z
z

x
t(i
x
(z))z
1
dG(z)
_
(85)
I here examine the change in the aggregate labour demand by all non-cuto rms, i.e.
those rms that do not change status (between non-producing, domestic and exporting)
following trade liberalisation for a constant M. This corresponds to the derivative of the
above expression treating M as given and neglecting the changes in the boundaries of the
integrals in the square bracket. It is of the sign of:

1
z

dz

d
_
_
z

x
z

t(i
d
(z))z
1
dG(z) + (1 +
1
)
_
Z
z

x
t(i
x
(z))z
1
dG(z)
_
+( 1)
2
_
Z
z

x
t(i
x
(z))z
1
dG(z) +
_
z

x
z

(i
d
(z))
di
d
(z)
d
z
1
dG(z)
+(1 +
1
)
_
Z
z

x
t

(i
x
(z))
di
x
(z)
d
z
1
dG(z) (86)
The rst part is the general equilibrium eect, which tends to decrease the labour
demand by all rms. The second part is the direct eect that increases the demand for
labour by all exporting rms to satisfy the increased demand on their export market. Note
that these rst two terms cancel using (45), exactly as in the standard framework. The
last two terms correspond to the change in labour demand for investment purposes.
Rearranging using (47) und (50), this expression is of the sign of:
2

2
_
Z
z

x
t(i
x
(z))z
1
E(i
x
(z))dG(z)
_
z

x
z

t(i
d
(z))z
1
E(i
d
(z))dG(z) + (1 +
1
)
_
Z
z

x
t(i
x
(z))z
1
E(i
x
(z))dG(z)

dz

d
1
z

(87)
34
Using (45), it is immediate that if E

(i) = 0, 2 = 0 and the same result as in the

standard case holds: the total labour used by existing rms not changing status does not
change when trade costs vary. This is due to the proportionality of the reaction of all
rms in their investment decision, so that the increase in investment by exporting rm
exactly absorbs the labour released by the drop in investment of non-exporting rms. If
E

(i) > 0, the numerator of the rst term above has relatively more weight than in the
case E

(i) = 0, so that the whole expression is positive: if large rms are more sensitive in
their investment decision, their positive eect on labour demand dominates. The opposite
conclusion holds for E

(i) < 0.
35