Trade liberalisation, quality upgrading, and export prices

Haichao Fan, Yao Amber Li , Stephen Yeaple

Trade liberalisation has transformed the economies of many developing countries. This column presents evidence from China’s accession to the WTO. The authors find that high tariffs on imported inputs prevented Chinese firms from producing high-quality goods. When these tariffs were reduced, firms upgraded the quality of their products, entering more competitive foreign markets.

Rapid trade liberalisation has transformed the economies of many developing countries. As these countries have scaled back tariffs, their firms have gained access to cheaper and higher quality intermediate inputs from abroad. A growing literature shows that trade liberalisation has led to a surge in imports of intermediate inputs and that the improved access to foreign-made inputs has had a large impact on firm productivity and product scope (e.g. Amiti and Konings 2007; Goldberg et al. 2010). Given the transformative impact of trade liberalisation on productivity, it is natural to consider the effect trade barriers may have had on firms' decisions regarding the quality of the products that they produce.

In Fan et al. (2014), we show that the greater access to imported inputs afforded to Chinese firms by China’s accession to the WTO induced Chinese exporters to upgrade the quality of the goods sold abroad. Quality upgrading, in turn, allowed Chinese firms to fetch better prices for their goods in existing markets and allowed these firms to break into markets in which demand for high quality goods is strong. Our results demonstrate that policies that might have been intended to foster the development of local input suppliers can have the unintended effect of handicapping a country’s exporters in the competition to offer high-quality products.

Import tariff reductions in China and export prices

As China joined the WTO in December of 2001, we compare data from 2001 (pre-liberalisation) with those in 2006 (post-liberalisation). We consider a wide range of tariff measures that collectively paint a more comprehensive picture of the extent to which Chinese producers were exposed to trade liberalisation. In particular, we create precise firm-level measures of import tariff reductions based on detailed information of import portfolio by each firm. This allows us to capture the true extent of within-industry variation in the size of the impact of trade liberalisation on individual firms. We find that Chinese firms experienced substantial tariff reductions with the maximum reductions in tariff levels of greater than 100% (see Table 1).

Table 1 Import tariff reductions in China (from 2001 to 2006)

Note: See Fan et al. (2014) for details of the construction of those firm-specific measures of tariff reductions. The original Chinese import tariff data are obtained from the WTO website, available as MFN (most-favoured nation) applied tariff. HS refers to the Harmonised System (HS) of tariff nomenclature that is an internationally standardised system of names and numbers to classify traded products.

What are the impacts of these massive tariff reductions on Chinese export prices? We care about prices because, intuitively, unit-value prices reflect product quality, i.e. high-quality goods usually sell at high prices.

We show that, in general, Chinese firms tend to raise export prices in the post-liberalisation period at both product-destination level and the product level.

Moreover, in industries in which products are highly differentiated, firms raise their export prices more substantially in response to a fall in the tariffs they pay on imported inputs.

In industries featuring primarily homogeneous goods, the pattern is ambiguous or even reversed – a reduction in imported intermediate tariffs results in lower prices (see Figure 1).

Figure 1. Distribution of log export prices by product differentiation (from 2001 to 2006)

Export prices, quality, and tariffs in theory

The aforementioned fact that export prices increase after trade liberalisation is not trivial. The conventional wisdom suggests that a reduction in the tariff on imported inputs lowers the firm's production costs and should therefore lead to lower export prices. But this prediction is not consistent with the Chinese experience. To explain this phenomenon, we build a model of firm quality choice. The intuition of the model is as follows. Tariff reductions lead to lower input costs, which in turn raise the volume of sales, so that overhead costs associated with product development can be spread over a larger sales base. This induces firms to upgrade their quality when sales respond enough to quality investment. Higher quality products increase demand but come at higher costs of production because higher quality products need better, and thus more expensive, inputs to produce. When goods produced are sufficiently differentiated in terms of quality, the impact of a tariff reduction on imports is an increase in quality of the exported product that is so large that the price of exports increases. When goods are homogeneous (i.e. there is little room for quality upgrading), quality also increases after tariff reductions but by a small enough amount that the price charged by the exporter falls due to the reduced input costs.

Estimated impact of tariff reductions on prices and quality

Though our model demonstrates that tariff reductions can induce firms to increase quality and export prices, empirically it is a challenge to verify that it is the tariff reductions that cause the changes and that those changes reflect quality upgrading. We estimate our model using panel data for Chinese firms over the period 2001-06, where quality is estimated using the information on product price and quantity sold based on the intuition that conditional on price, a product with a higher quantity indicates higher quality.

Compared with the literature that relates output quality to imported inputs (e.g. Manova and Zhang 2012; Verhoogen 2008; Kugler and Verhoogen 2009, 2012), we go beyond cross-sectional comparisons among firms to carefully investigate the causal impact of trade liberalisation on firm output quality, holding firm identities fixed. By comparing the prices and quality for the same product in the same destination market by the same firm before and after trade liberalisation – the finest disaggregation afforded by the data – we eliminate many potential sources of spurious correlation, such as destination country-, product- or firm-specific factors that may affect prices and quality. We also document how individual firms respond to improved access to imported intermediates by shifting their export sales to markets where demand for high-quality goods is strong.

In the baseline regressions, we find that a fall in firm-specific import tariffs of 10 percentage points increases unit value export prices at the firm-product-destination level by 4.8-5.2%.

Firms that face a larger reduction in the tariffs imposed on their imported inputs increase rather than decrease their export prices when the good is in an industry where the scope for quality differentiation is large, but not when the exported good is in an industry where the scope for quality differentiation is small.

This result is robust to the inclusion of a wide range of time-varying firm controls, alternative measures of tariff liberalisation, and samples confined to only small firms that have little room to adjust mark-ups. Importantly, the result is not obtained in a sample of export processing firms that were never subjected to tariffs. In addition, we present indirect evidence at the extensive margin of quality upgrading – firms experiencing large reductions in tariffs on their imported intermediates tend to enter new markets with relatively highly priced goods and exit markets where prices had tended to be low.

Conclusion

Our analysis uncovers patterns of price and quality adjustments in the wake of trade liberalisation that strongly suggest that access to imported intermediate inputs can substantially increase the ability of firms to deliver high-quality goods to foreign markets. We first document price adjustments across firms and then devise an econometric model from a simple analytical framework of quality choice and access to imported intermediates. Estimating this model on Chinese data before and after WTO accession, we find strong and robust evidence that those firms in industries where quality heterogeneity is substantial and that experience the largest tariff reductions on their imported inputs, increase the price and quality of their outputs.

References

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Amiti, M and J Konings (2007), “Trade Liberalization, Intermediate Inputs, and Productivity: Evidence from Indonesia”, American Economic Review, 97 (5), 1611–1638.

Goldberg, P K, A K Khandelwal, N Pavcnik, and P Topalova (2010), “Imported Intermediate Inputs and Domestic Product Growth: Evidence from India”, The Quarterly Journal of Economics, 125 (4), 1727–1767.

Fan, H, Y A Li, and S R Yeaple (2014), “Trade Liberalization, Quality, and Export Prices”, NBER Working Papers 20323, National Bureau of Economic Research, Inc.

Kugler, M and E Verhoogen (2009), “Plants and Imported Inputs: New Facts and an Interpretation”, The American Economic Review, 99 (2), pp. 501–507.

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Manova, K and Z Zhang (2012), “Export Prices Across Firms and Destinations”, The Quarterly Journal of Economics, 127, 379–436.

Verhoogen, E A (2008), “Trade, Quality Upgrading, and Wage Inequality in the Mexican Manufacturing Sector”, The Quarterly Journal of Economics, 123 (2), 489–530.