Is the best offense a good defense?: theory and evidence of trade-induced defensive innovation in developing countries

In the theoretical model I present in this dissertation, I make predictions of a firm's defensive response to trade liberalization both in a regime of entry deterrence and one of entry accommodation. Using an oligopoly framework, the model predicts that a domestic firm will make investments in skill-intensive technologies in order to prevent entry of a foreign firm. I refer to this as entry deterrence defensive innovation. With a large drop in tariffs, where entry deterrence is not feasible, the domestic firm responds to foreign entry in one of two ways. They can meet the increase in foreign imports with an increase in investment. In this case, there would be a negative relationship between investment and tariffs, which I refer to as entry accommodation defensive innovation. Alternatively, domestic firms may respond to the entry of foreign competitors by decreasing their investment. This scenario would be seen with a positive relationship between tariffs and investment and is called entry accommodation capitulation. Extending the model to include multiple home firms, I am also able to predict that the greater is the number of home firms, the smaller is the defensive response to foreign entry.

I then empirically test the implications of the model using the Brazilian, Mexican, and Colombian trade liberalizations, which all began in the mid-1980's, as natural experiments. I find support for defensive innovation as an entry deterrence strategy in both Brazil and Mexico. Specifically, I find that, when foreign entry is deterred, a decrease in tariffs is associated with an increase in investments in R&D and computers and in the relative demand for skilled workers in Brazil and investments in machinery in Mexico. I also find evidence in all three countries that the level of domestic competition has a significant impact on the defensive response of domestic firms to foreign entry is deterred. When entry is accommodated, my findings support a strategy of defensive innovation being employed in Mexico and Colombia and capitulation occurring in Brazil.

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