Can Both the United States and China Be Winners in a Global Technology Race?

The Issue:

Recent trade barriers erected by the Trump administration are motivated in part by fear of China’s “Made in China 2025” program. This program aims to increase Chinese innovation and upgrade the production methods used in Chinese manufacturing from labor-intensive to high-tech. There is also anxiety in the United States about the erosion of the U.S. lead in patenting and scientific publications. Chinese applications for patents under the World Intellectual Property Organization’s Patent Cooperation Treaty rose 13 percent from 2016 to 2017, moving China above Japan to 86 percent of the U.S application level. The firms filing the largest numbers of patents during that year were the Chinese companies Huawei Technologies and ZTE Corporation, ahead of Intel Corporation. Are advances in Chinese technology bad for the United States?

Are advances in Chinese technology bad for the United States?

The Facts:

• Technological innovation, of which patents are one measure, is an important contributor to economic growth. At the firm level there is a race to innovate. Firms that innovate grow faster, while firms whose rivals innovate grow more slowly. For instance, a recent study that looked at innovation in the economy over several decades found that firms that generated more valuable patents grew 2.5 to 4.6 percent faster over a period of five years. In contrast, firms that failed to innovate in technologically advancing industries saw lower growth in the range of 2.7 to 5.1 percent over the same time horizon. This creates a dynamic of workers and resources shifting to the more innovative firms. At the country level, firms’ collective innovation spurs productivity growth and hence overall economic growth.
• Innovation in one country benefits other countries. American consumers or American firms using intermediate goods or services can benefit from foreign innovation through trade: they may buy imports of the new, improved or cheaper products that are the fruit of the foreign innovation. Even more importantly, innovations made abroad are often adopted in the United States: researchers estimate that while 60 percent of U.S. productivity growth stems from domestic innovation, the rest comes from innovation abroad. In theory, technological advancement abroad could be detrimental to the United States by diminishing gains from trade: As countries become more similar in terms of technology, worker skills, and capital, there is less scope for gains from trade that originate in comparative advantage – countries specializing in what they do best. Historically this has not proven to be the case. As Europe has converged with the United States since the Second World War, aided by the acquisition of American technology, trade between Europe and the United States has increased rather than decreased. This trade is stimulated by the reduced cost of producing on a large scale: similar countries now specialize in particular products within an industry and import other products in the same industry (see here).
• However, the benefits generated by domestic innovation are greater than those derived from innovation abroad. Foreign innovation is generally adopted only with a lag and cannot always be implemented seamlessly, as it has been developed to optimize performance under different conditions – for example, for a workforce with different skills (see here). Research has shown that even within a country, innovation spillovers among innovators decline rapidly with distance.
• Because the benefits of technological progress to society are greater than the benefits that accrue to the individuals or firms that innovate, most governments of high-income countries, including the United States, subsidize research and development. The benefits of technological progress accrue to society more generally and not just to the innovating firm, cancelling out the losses incurred by less innovative firms. Broader beneficiaries include consumers of new, improved or cheaper products; firms using inputs made with new technology; non-innovating firms which use the technology once it loses patent protection; and developers of even newer technology made possible by the earlier innovation. This public good aspect of technological progress is presumably one motivation for Made in China 2025. The Chinese government also presumably believes that the short-term cost will be recouped in longer-term economic growth caused by better technology. This has been a common strategy of countries in an early stage of development, though studies of its effectiveness have not yielded clear conclusions. Some researchers have found government industrial interventions that result in greater productivity growth under some circumstances. But other studies have observed that when governments favor some companies over others in a discretionary fashion, the results have been diminished competition and increased opportunities for vested interests to try to influence policy (see here).
• When foreign governments subsidize their firms, the American companies that compete with them are hurt. But, American consumers enjoy lower import prices, leaving Americans as a whole better off. Subsidized firms can offer lower prices than unsubsidized firms, reducing profits for the unsubsidized firms or even driving them out of business. However, lower prices help consumers or firms buying intermediate goods and services. Subsidies distort markets and make the subsidizing country and the world economy worse off — unless they lead to improved technology. Still, the net effect is positive in countries not paying for the subsidies: they are receiving a gift from the subsidizing country. However, the introduction of subsidies by a foreign government does lead to short-term domestic adjustment costs as firms and workers re-orient their activities, so foreign subsidies must be long lasting to be beneficial domestically. The adjustment costs must be incurred again if the foreign government ends the subsidies.
• There are exceptions, though. Foreign improvements in military technology could be detrimental to the United States. If they lead to an arms race this makes the United States poorer. And, if they lead to war, the cost is even greater. In addition, there is a difference between government policies that stimulate domestic innovation and policies that encourage or facilitate the forcible acquisition of technology developed abroad. The benign view of technology transfer does not extend to industrial espionage. If the fruits of innovation are stolen, firms will lose their incentive to innovate, reducing domestic and possibly world economic growth.
• The Chinese government’s large subsidies to solar energy technology in recent years exemplify some of the issues. The subsidies reduced production costs directly, but also indirectly through innovation and the expansion of the scale of production, resulting in exports of cheap solar panels throughout the world (see here). Though American solar panel producers could not compete, Americans are better off. However, changes to China’s solar energy subsidies announced in 2018 – reductions in subsidies to domestic use of solar energy, but not production of solar energy — are expected to cause renewed disruption in the United States and elsewhere. It is not clear whether China’s large solar energy subsidies have been beneficial to China, but the fact that private companies do not take into account improvements to the environment makes the provision of at least some subsidies desirable.