Firm Heterogeneity and Growth Through Product Variety and Upgrading Choices

Abstract: Japan, whose remarkable development story prompted Robert E. Lucas to place it in a category of its own in his account of world economic growth since the Industrial Revolution, started its transformation from a poor backward to a modern industrial nation in the late 19th century by growing its cotton spinning industry—the same industry that had been the key to industrialization in England and elsewhere. In this paper we conduct an in-depth theoretical and empirical investigation of key factors influencing innovations, product upgrades, and product diversification in this industry. The literature on industrial organization and international trade has recognized the importance of heterogeneous firms’ choices of what products to produce, but this work has focused largely on supply-side determinants of this decision. We propose a novel approach focusing on embodied diffusion of knowledge not just about the supply side (production technologies) but also (and even more so) about the demand side (markets, reputation for quality and reliability, customers’ willingness to pay, etc.). We employ hand-constructed, detailed “nanoeconomic” data on cotton spinning in Meiji-era Japan, to investigate complementarities between demand- and supply-side management in both steady state product variety and product innovation. This leads to a richer notion of firms’ product variety choices and the factors behind interfirm productivity differentials. It also highlights the sources and relative importance of incumbent advantage, as opposed to simple “disruption” notion that innovators replace incumbents.