Trade Reforms, Competition, and Innovation in the

PhilippinesRafaelita M. Aldaba

Intercontinental Hotel, Makati CityNovember 14, 2014 3:30-5:00 PM

52nd Philippine Economic Society Annual MeetingScience, Technology, Research & Innovation for

Development (STRIDE) Panel

Main Objective• What is the impact of trade liberalization on

the manufacturing firms’ innovative activities?• With competition as the main channel linking

trade reforms with innovation, did the increase in competition arising from trade reforms lead to increases in innovation?

OutlineI. Industry indicators: trade, growth,

performance & structure, innovation/R&D II. Theoretical Literature: Trade, competition

and innovationIII. Empirical modelIV. Data & analysis of regression resultsV. Broad conclusions & policy suggestions

Part I. Industry BackgroundAverage Manufacturing Tariff

Rates

• increases from 2002-2004, widening of tariff dispersion between 1998 and 2004

Effective Protection Rates: 1985-2004

• Tariff reforms substantially reduced protection

Performance by sector

• Mfg growth sluggish from 1980s-1990s, modest gains 2000s

Growth Rate 1950s 1960s 1970s 1980s 1990s 2000s

GDP 6.2 4.8 5.7 1.7 3.0 4.7

Agri,Fishery,Forestry 4.8 4.2 3.9 1.1 1.8 3.0

Industry Sector 7.1 5.5 7.6 0.3 3.0 4.2

Manufacturing 9.4 5.7 5.9 0.9 2.5 4.1

Service Sector 6.7 4.7 5.2 3.3 3.6 5.8

Value Added 1950s 1960s 1970s 1980s 1990s 2000s

Agri,Fishery,Forestry 32.5 29.7 25.6 23.9 20.8 18.9

Industry Sector 30.6 32.6 38.3 38.0 34.1 33.1

Manufacturing 22.3 25.6 28.2 26.3 24.3 23.7

Service Sector 38.3 38.4 36.6 40.4 42.4 48.0

Employment structure

• Mfg failed to create enough employment to absorb new entrants to labor force 800K new entrants/year 3M unemployed ; 7.3M underemployed Services cannot provide all the needed jobs Manufacturing can employ skilled, semi-skilled, unskilled Need for structural transformation

1975-78 1980-89 1990-99 2000-09

Agri,Fishery,Forestry 52.83 49.60 43.16 36.1

Industry Sector 15.23 14.49 15.98 15.1

Manufacturing 11.29 9.93 10.01 9.1

Service Sector 31.87 35.90 40.94 48.8

Manufacturing value added structure

• Consumer products dominated, intermediate products declining

1981-89 1990-99 2000-10

Consumer Goods 57 50 51 Food manufactures 44 36 40 Beverage industries 4 4 4 Footwear & wearing apparel 5 6 4Intermediate Goods 31 35 27 Chemical & chemical products 7 6 6 Products of petroleum & coal 12 17 14Capital Goods 10 13 19 Basic metal industries 3 2 3 Electrical machinery 3 6 12

Total factor productivity growth, 2006

• Mfg TFP growth declined due to failure to invest in state of the art technology, lack of investment in human capital, lack of movement of resources towards manufacturing

Industry TFP Industry TFP

All manufacturing -3.37 coke, petroleum, chemicals & rubber

-4.76

food, beverages, & tobacco

-1.44 non-metallic products -0.65

textile 2.35 basic metal & fabricated metal 1.32

garments 0.99 machinery & equipment, motor vehicles & other transport

-0.86

leather 9.54 furniture 1.86

wood, paper, & publishing

-3.85 Other manufacturing 0.63

Market concentration

• Manufacturing industry already contestable, CR4 in most sectors below 35%, except for certain sectors with CR4 ranging from 62 to 82%

Industry CR4Coke, Refined Petroleum and other Fuel Products 79.8Tobacco Products 72.0Beverages 62.4Other non-metallic: flat glass 82.4Motor Vehicles, Trailers, and Semi-trailers 57.2Food 55.7Other Non-Metallic Mineral products 54.3

Price Cost MarginsSector Roeger

MethodSimple Method

Beverages 0.62*** 0.53Tobacco 0.59*** 0.47Pottery, cement & other nonmetallic 0.60*** 0.57Glass and Glass Products 0.50*** 0.52Other chemicals 0.45*** 0.37Paper and Paper Products 0.38*** 0.36Industrial chemicals 0.38*** 0.35Rubber products 0.34*** 0.28

• Industry average is 29%, low from 8 to 19%, moderate from 22 to 38%, but for certain sectors high PCM from 45% to 62%

R&D as % of GDP & R&D per capitaYEAR 2002 2003 2004 2005 2006 2007 2009

PHIL 0.14 0.13 ... 0.11 ... 0.11 …SING 2.10 2.05 2.13 2.19 2.16 2.36 2.2THAI 0.24 0.26 0.26 0.23 0.25 0.21 0.25MAL 0.65 ... 0.60 ... 0.61 … 1.01INDO ... ... ... … ... … 0.08

YEAR 2002 2003 2004 2005 2006 2007PHIL 3.8 3.7 ... 3.4 ... 3.6SING 800.9 795.1 878.6 945 986.4 1145.5THAI 14.3 16.3 16.7 16 17.7 15.9MAL 70.4 ... 70.4 ... 76.8 106.5 (‘08)INDO ... ... ... ... 3.1 (‘09)

• In PPP$, constant 2005 prices

No. of researchers: total & per million inhabitants

YEAR 2002 2003 2004 2005 2007

PHIL ... 9390 ... 9407 9357SING 21871 23514 21359 28586 32198THAI ... 42379 ... 36967 42624MAL 10731 ... 17887 ... 13416

YEAR 2002 2003 2004 2005 2007PHIL ... 114 ... 110 779SING 5288 5527 5826 6359 6840THAI ... 657 ... 564 645MAL 440 ... 705 ... 816(‘08)

• Philippines has been underinvesting in R&D

Part II. Literature Review(1).Competition & Innovation

• Early endogenous growth & IO literature: competition is detrimental to innovation, rents are major source of innovation

• Opposite view: competition fosters innovation , forces firms to innovate to survive, firms escape competition from rivals

• Aghion et al (2001): inverted U-shaped relationship between competition & innovation

• Empirical studies: mixed results with more recent studies pointing to a positive relationship between competition & innovation

• Creusen et al(2006), Hopman & Rojas-Romagosa (2010): positive relationship, no evidence of inverted U

• Gorodnichenco et al (2009): negative relationship especially for firms far from frontier, no evidence of inverted U

(2). Trade & competition • Trade has a pro-competitive effect, open trade regime is a

powerful instrument to discipline firms that have market power

• Import discipline hypothesis: competition from imports constrains ability of firms to engage on anti-competitive activities

• Empirical work: strong evidence supporting IDH• Erdem & Tybout (2003), Tybout (2001):mark-ups decline with

import competition• Harrison (1994), Krishna & Mitra (1998), De Melo & Urata

(1986), Levinsohn (1993), Warzynski (2002), Warzynski et al (2002)

• Trade & productivity: industries facing greatest tariff reduction & import competition have faster productivity growth

• Pavcnik (2002), Topalova (2003), Muendler (2002), Amite & Konings(2007), Schor (2003), Fernandes (2007), Aldaba (2010)

(3). Trade & innovation• International trade affects innovation through

competition• Aghion & Burgess (2003): liberalization

encourages innovation in industries close to frontier

• Griffith, Harrison & Simpson (2006): EU SMP product market reforms increased competition which led to an increase in R&D

• Fernandes (2009): import competition has a positive effect on product quality upgrading

• Bloom, Draca & V. Reenen (2010):Chinese import competition increases innovation & TFP within surviving European firms, it reduces employment & survival probabilities in low-tech firms & they exit much more rapidly than high-tech firms in response to Chinese competition

Trade, competition, innovation• Trade increases competition, through competition

channel, it has positive effect on innovation & leads to selection of most productive firms

• Trade liberalization induces least productive firms to exit & most productive non-exporters to become exporters (Pavcnik, Topalova, Tybout)

• Impulliti & Licandro (2010):links these 3 effects, trade affects both selection & innovation thru competition, tradelibfirms, competition, mark-upprofit, productivity threshold above which firms can profitably produceless productive firms exit, resources reallocated from exiting firms to higher productivity surviving firms which innovate at faster rate

Part III: Analytical FrameworkTrade liberalization affects innovation through competition

• where i indexes firms, j industries and t years• Z is a vector of control variables that may affect the firm’s

innovation efforts: TFP gap, age, total workers, entry and exit indicators

• model is estimated using a two-stage instrumental variables (IV) technique & Tobit regression

• 2 trade indicators: EPRs & output tariff rates • Firms are grouped based on trade orientation: non-traded, purely

importable, purely exportable, mixed sector

Specific model• Competition function

• Innovation function

PCM: price cost margin Tariff and EPR: trade reform indicator TGap: technology gap, distance to the technological frontier RD: research and development expenditures Age, Size, Exit and Entry : firm characteristics + relationship between competition & trade, tariff PCM or profitability, with competition, competition is main channel through which trade affects innovation - relationship between competition & innovation, inefficient firms will be forced out of the market, resources reallocated to more productive surviving firms’ who innovate at a faster pace

Part IV. Data & Analysis of ResultsSummary Statistics: All Mfg

Variable Obs Mean Std. Dev. Min Max

Total revenue (P million) 8296 736 5200 0.065 233000

Compensation (in P million) 8296 43 141 0 2640

Total costs (in million pesos) 8296 594 4510 0.026 203000Book value of fixed assets 8296 180 1000 0 47600Capital cost 8296 0.07 0.059 0.03 0.219Financial cost of capital 8296 15 102 0 5750Price cost margin 8296 0.053 0.259 -6.086 0.96

R&D (as % of value added) 8296 0.005 0.068 0 5.373Age of firm (in years) 8263 17 14 0 100Total number of workers 8296 264 703 10 14647TFP Gap 8296 0.371 0.146 0 1.054Tariff (in percent) 8296 9.087 6.309 1.073 60Net entry 8296 -3 6.9 -52 6

• Panel data covering 8 years from 1996 to 2006

Summary Statisticsby trade orientation

Non-traded Purely Importable

Purely exportable

Mixed sector

Variable Obs Mean Obs Mean Obs Mean Obs Mean

R&D (%) 377 0.0018 775 0.0045 628 0.0026 6516 0.0055

PCM 377 0.0372 775 0.0920 628 0.0548 6516 0.0495

No. workers 377 174 775 210 628 109 6516 291

Age 373 15.4 771 18.6887 624 18.5016 6495 16.3150

TFP gap 377 0.3859 775 0.3551 628 0.3508 6516 0.3740

Tariff 377 9.2912 775 13.3604 628 8.9374 6516 8.5812

EPR 377 12.0489 775 10.0601 628 13.6641 6516 13.7386

• Non-traded: exports & imports are 0 or <1% (custom tailoring, slaughtering); purely importable: minimal exports & significant imports (atleast 10%, meat products, butter, cheese, auto assembly); purely exportable: minimal imports & significant exports (tobacco leaf); mixed: substantial imports & exports (auto parts & components, semi-conductor, chemicals, soap)

All Manufacturing: IV RegressionSTAGE 1 STAGE 2

PCM TARIFF EPR RD TARIFF EPR

Age 0.00031 -0.0007018* PCM -0.114983* -0.11895510.0026855 0.0004111 -0.0704618 0.1272509

Workers -0.00001 -0.0000282*** Age -0.00044 0.00009550.0000128 0.00000648 -0.0005744 0.000136

TFP Gap-2.54176***

-1.864594*** Workers-

0.00000538* -0.000004220.1052527 0.0532788 -0.00000285 0.00000396

Trade 0.0069049*** -0.000508 TFP Gap -0.11871 -0.10179990.0022272 0.0004102 -0.1816651 0.2370014

Constant 1.096718*** Constant 0.09242 0.0000826

0.1022577 -0.0904484 0.0001225Year Y Y Year Y YIndustry Y Y Industry Y YObs 8263 8263 Obs 8263 8263 R2 0.0672 0.0723 R2 0.0044

All Manufacturing: Tobit RegressionSTAGE 1 STAGE 2

PCM TARIFF EPR LNRD TARIFF EPRTrade 0.0012992*** 0.0000996 PCM -10.44935* -10.05107

-0.000547 -0.0001304 -5.906214 -17.95807

Workers -0.0000211*** -0.000021*** Workers -0.0005009*** -0.0004926

-0.00000405 -4.05E-06 -0.0001365 -0.0003815

Age -0.0003406* -0.0003545* Age -0.0064991* -0.0063593

-0.0002017 -0.0002018 -0.0035068 -0.0068841

TFP Gap -1.242917*** -1.234866*** TFP Gap -5.04204 -4.551069

-0.0393622 -0.039239 -7.30149 -22.14417

Constant 0.4478913*** 0.4647943 Constant -0.5995352 -0.7849602

-0.0196814 -0.0182534 -2.761603 -8.364468

Year Y Y Year Y Y

Industry Y Y Industry Y Y

Obs 8263 8263 Obs 8263 8263

R2 0.1207 0.12 R2 0.1207 0.12

IV Regression: Mixed SectorSTAGE 1 STAGE 2

PCM TARIFF EPR RD TARIFF EPRAge

-0.0006029 -0.0007068 PCM-.1295984*

-0.0906546 -0.0004183 -0.0004806   -0.0682428 -0.0678799

Workers -.0000288***

-.0000277***

Age0.0001018 0.0001219

-6.37E-06 -6.69E-06   -0.0001255 -0.0001337

TFP Gap -1.855282***

-1.983007*** Workers -3.80E-06 -3.09E-06

-0.0592093 -0.061406   -2.70E-06 -2.58E-06

TRADE .006108*** .0017411***

TFP Gap -0.1114657 -0.0453125-0.0014744 -0.000455   -0.126285 -0.1348436

Constant CONSTANT 0.0527683 0.0256419-0.0512104 -0.0546182

YEAR Y Y YEAR Y YINDUSTRY Y Y INDUSTRY Y Y

OBS 6495 6495 OBS 6495 6495

R2 0.0736 0.0723 R2 0.0045 0.0043

STAGE 1 STAGE 2PCM TARIFF EPR LnRD TARIFF EPRAge -.0003994 * -.0003936* PCM -5.733137 -8.414397 -0.0002435 -0.0002436   -3.639965 -6.594807

Workers -.0000216***

-.0000219***

Workers -.0003721*** -.000431***

-4.33E-06 -4.34E-06   -0.0000925 (.0001546)*

TFP Gap -1.332122***

-1.322314*** Age -.0060584** -0.0070863

-0.0474155 -0.0472372   -0.0029606 -0.003938

TRADE .0030229*** .0005372* TFP Gap 0.9419193 -2.583998

-0.001026 -0.0002858   -4.813166 -8.691929

Constant.4655379***

.5039854*** CONSTANT

-5.503807***

-4.12588

-0.0301794 -0.0258772 -1.890225 -3.403656YEAR Y Y YEAR Y YINDUSTRY Y Y INDUSTRY Y Y

OBS 6495 6495 OBS 6495 6495

R2 0.1189 0.1182

Mixed Sector: Tobit Regression

Mixed Sector: IV Regression (net entry)STAGE 1 STAGE 2

 PCM TARIFF EPR LNRD TARIFF EPRAge -0.0005626 -0.0006576 PCM -0.1336937* -0.0956812  0.0014297 0.00045   0.0724602 0.0727616Workers

-0.0000292***-

0.0000285*** Age 0.0001007 0.0001196  0.0003939 0.00000654   0.0001213 0.0001289TFP Gap -1.793328*** -1.919879*** Workers -0.00000371 -0.00000302  0.00000622 0.0603512   0.00000281 0.00000274Net Entry -0.0005875 -0.000747* TFP Gap -0.1139012 -0.0523605  0.0581184 0.000448   0.1294799 0.139814Trade 0.0057119*** 0.0016159*** Net Entry 0.0001094 0.0001017

0.0004647 0.0004418 0.0001416 0.0001321Constant 0.734464*** Constant 0.0519422 0.0286122

0.0323591 0.0506673 0.05666OBS 6495 6495 OBS 6495 6495R2 0.0723 0.0723

0.0045 0.0043

Mixed Sector: Tobit Regression (net entry)STAGE 1 STAGE 2

 PCM TARIFF EPR LNRD TARIFF EPRAge -0.0004035* -0.000397* PCM -6.083573* -8.772339  0.0002437 0.0002438   3.682705 6.686467Workers -0.0000216*** -0.0000218*** Age -0.0059966** -0.0070351*  0.00000434 0.00000434   0.0030161 0.0040205TFP Gap -1.331775*** -1.321962*** Workers -0.0003815*** -0.0004406***  0.0474237 0.047248   0.0000937 0.0001567Trade Ind 0.0030443*** 0.0005407* TFP Gap 0.4578945 -3.076967  0.001027 0.000286   4.868762 8.810686Net Entry 0.0002632 0.0002235 Net Entry -0.013027** -0.0125073*

0.0005458 0.0005457 0.0059947 0.0070161Constant 0.4598655*** 0.4916265*** Constant -2.754255 -1.409861

0.0267683 0.0235211 1.85854 3.355992OBS 6495 6495 OBS 6495 6495

R2 0.1188 0.1181

Part V. Conclusions & policy Implications

• Trade liberalization affects firm innovation through competition An increase in tariffs will increase profitability & reduce competition

likely result in reduced innovation, holding all else equal• For overall manufacturing, both IV & Tobit results show that with

tariff as trade indicator, trade reform has a strong positive effect on competition which leads to a significant positive impact on innovation activity

• Mixed sector, where intense trade takes place, confirms the importance of market competition as channel through which trade liberalization affects innovation

• IV results with tariffs show that tariff & PCM have a highly significant positive relationship while R&D & PCM have a significant negative relationship

Policy Implications• Considering the low level of R&D spending, overall

innovation activity in the country, and role of competition in the relationship between international trade & innovation, maintaining effective competition is essential, market contestability important– Increasing globalization & regional economic integration

• Government should design strategy that would ensure competition, innovation, & productivity growth of firms

• Motivations for new industrial policy – Inclusive growth, ASEAN Economic Community

• Transform & upgrade manufacturing – AEC opportunities & create more & better jobs

• Strengthen human capital, infrastructure, institutions • Innovation Ecosystem to link business & academe

“ Innovations do not fall like manna from

heaven. Instead, they are created by human beings……. to profit from opening up new markets….”

Aghion and Howitt (1999)