Industrial and Trade Policy in Supply Chains

Industrial policies, traditionally aimed at boosting the competitiveness of protected sectors, can inadvertently drive productivity growth in downstream sectors abroad. The paper presented in this Mannheim Applied Seminar provides evidence for this mechanism by examining the case of rare earth elements – essential inputs for many manufacturing products and the green transformation. To measure the importance of rare earth inputs across manufacturing industries, the authors construct an input-output table that incorporates individual rare earth elements as inputs. They find that exports in rare earthintensive downstream sectors outside of China increased after the Chinese supply restrictions on rare earths. Using data on patents and sector TFP, the authors then show that this uptake in exports coincides with a surge in innovation towards more efficient usage of rare earth inputs. They develop a trade model with directed technical change that explains these findings, showing that industrial policy can shift the direction of innovation and drive growth in downstream sectors abroad when inputs are gross complements. The authors also introduce a new method for estimating production elasticities based on innovation direction and relative input prices, consistent with their trade model, and find evidence for rare earths being complementary production inputs.