Credit constraints, endogenous innovations, and price setting in international trade

We introduce credit frictions motivated by moral hazard in a
general equilibrium model of international trade with two
dimensions of heterogeneity and endogenous investments. Firms’
competitiveness consists of capabilities to conduct process and
quality innovations at low costs, whereas investment outlays have
to be financed by external capital. We show that the scope for
vertical product differentiation in a sector determines how credit
tightening affects investment and price setting. Consistent with
recent empirical evidence, our model rationalizes positive as well
as negative correlations of firm-level FOB prices with financial
frictions and variable trade costs. Faced with an increase in the
borrowing rate, producers reduce both types of innovation resulting
in opposing effects on marginal production costs and prices. In
general equilibrium, financial frictions intensify quality-based
(cost-based) sorting of firms if the scope for vertical product
differentiation is high (low). Consequently, credit tightening
leads to firm exit, increased innovation activity among existing
suppliers, and welfare losses that are larger in sectors with low
investment intensity.