The Role of Openness in Industry Dynamics: A Model of Innovation and Technology Diffusion in Developing Industries

We propose a theoretical model linking the openness of an economy to rates of innovation and technology diffusion in its developing industries. Openness to foreign trade affects the size of the market faced by domestic industries and therefore affects the optimal level of investment in innovation and efforts to prevent knowledge spillovers. We show that while an industry‟s output is small relative to the global market and imitation does not cause price destruction effects, it is optimal for innovating firms to allow imitation by other nearby firms, but as the industry grows, it becomes increasingly likely that the optimal strategy will be to conceal such knowledge. We then demonstrate that if a country adopts protectionist measures, technology diffusion typically stops before the industry develops enough to compete at world prices, so that such a policy is likely to be self-defeating. In contrast, under free trade, the diffusion of innovations will continue at least until an industry becomes globally competitive, although it may initially grow more slowly.