Trade and Industrial Policy in Supply Chains: The Case of Rare Earth Elements

Industrial policies, traditionally aimed at boosting the competitiveness of protected sectors, can inadvertently drive productivity growth in downstream sectors abroad. We provide 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, we construct an input-output table that incorporates individual rare earth elements as inputs. We find that exports in rare earth-intensive downstream sectors outside of China increased after the Chinese supply restrictions on rare earths. Using data on patents and sectoral TFP, we then show that this uptake in exports coincides with a surge in innovation towards more efficient usage of rare earth inputs. We 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. We also introduce a new method for estimating production elasticities based on innovation direction and relative input prices, consistent with our trade model, and find evidence for rare earths being complementary production inputs.