We propose and provide evidence for a new source of gains from trade: Firms invest in product differentiation to escape import competition. In the data and in the model, these investments are associated with increases in measured productivity, introduction of new goods, and shifts to skill-intensive sectors. Investment in differentiation downstream leads upstream firms to also invest in differentiation. For China, these "downstream tariff" reductions lead to big increases in measured productivity for upstream suppliers. The effect on measured productivity is larger for upstream than for downstream firms, and we explain this difference theoretically through heterogeneous changes in markups.
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