Trade Across Firms within

Industries*
Dr Soumyatanu Mukherjee
Assistant Professor, Economics Area, IIMK
External Fellow: CREDIT & GEP, University of Nottingham (UK)
18.10.2016

* These presentation is based on, to a very large extent, the materials compiled by Prof. Daniel Bernhofen (now at American
University), who explained us these papers on firm heterogeneity models of trade very lucidly in my PhD International Trade
Course at University of Nottingham on 2013-14; and kindly permitted me to use his materials. Any errors are entirely of my own
responsibility.
 Stylized facts on Exporting firms
The Krugman (1980) and Helpman-Krugman (1985) model features “universal” exporting by
firms in a differentiated product industry:
 Every brand is produced just by a single firm in one country, which exports its output everywhere else in
the world;
But,

Source: World Trade Organisation (2008, table 5)

 Stylized facts on Exporting firms
 Only a small fraction of firms export;
 Exporters sell most of their output domestically;
 Exporters are bigger than non-exporters;
 Exporters are more productive than non-exporters.

Source: World Trade Organisation (2008, table 6)

 So What??
This suggests that the most productive firms self-select into export
markets, (Note that it could also reflect learning by exporting).

 Micro-level studies found evidence of reallocation effects within an industry

following trade liberalization.
 The least productive firms to exit (Bernard and Jensen, 1999).
 Market share reallocation towards more productive firms (Pavcnik 2002)
=> Increase aggregate productivity.

Þ Theoretical framework should include two features:

1. Within sectoral heterogeneity in size and productivity.

2. A feature that leads only more productive firms to export: This could be
fixed or sunk costs of exporting
 Melitz (2003)
•   sectoral heterogeneity in firms’ productivity
Within

 The demand side is CES (like Krugman; 1980): Yields constant elasticity demand functions
 On the supply side:
 Monopolistic competition; every variety is produced by a single firm and there is free entry into the industry.
 Constant marginal costs and a fixed overhead production cost in terms of the single composite input (e.g.
skilled + unskilled labour).
Total Cost:
 The fixed cost is identical across all firms with same ; denote it by .
 The constant marginal cost 1/ (taking the common wage rate as numeraire) varies across firms.

 Firms with higher are more productive: Higher productivity firms charge lower prices, earn higher
revenue ( elastic demand), and obtain higher profits.
 Melitz (2003)

• Firms’
  revenue-based productivity (such as
deflating sales with firm-specific price-deflators)
, is increasing in & gets more thinly distributed over
units of revenue
 Prior to entry, firms face productivity uncertainty:
 A firm pays a fixed cost of entry fe ;

 It then draws its productivity from a fixed

distribution with CDF G;
 After observing , a producer decides whether to exit or
produce.
 Survival Productivity cut-off & market demand are
respectively determined by the zero profit condition of
the firm and zero expected ex-ante net profit
condition for the industry.
 Melitz (2003): The Open Economy
• the
In   open economy there are two types of trade frictions:
1. A standard iceberg cost t.
2. An initial fixed cost fx to start exporting, which is incurred once the firm has learned

 Market shares are reallocated to exporters.

 Melitz (2003): Predictions
•Effects
  of trade liberalization (reduction in ‘iceberg’ transportation cost):
1. The exporters should increase their sales abroad;

2. Most productive, non-exporters earlier, also start exporting;

3. Some of the lesser productive domestic firms should exit the market because of stronger import
competition owing to entry (goes up).

Reallocation of the market shares from the least to the most productive firms  Increase of the
aggregate/average productivity of the industry. This is the extra adjustment margin (extensive margin)
absent in Krugman’s New Trade Theory models. In fact, the overall welfare gains from trade are composed
of both increases in average productivity and changes in variety.
Hence, there are larger welfare gains from reductions in trade costs and smaller welfare losses from
increases in trade costs in the heterogeneous firm model than in the homogeneous firm model.
 Melitz-Ottaviano (2008)
• Addresses 2 major caveats in Melitz (2003):
– Fixed price mark-up due to CES preferences.

– Selection effect independent of market size and hence on the “toughness” of

competition.

• Addressing for “tougher” competition itself necessitates the

consideration of variable mark-ups in heterogeneous firm models.
• Differences in competition across markets then feed back and
influence firm location and export decisions.
 Melitz-Ottaviano (2008) – Closed Economy
• A
  monopolistically competitive industry with many firms, competing with each
other by offering different products that are relatively close substitutes for one
another. Firms differ only with respect to (MC).
 
Just like Melitz (2003), both firms enter as
  a)   b) both & are below the survival threshold,
(which equals the “choke price” here);
  c) however, firm 2 discovers that is too high to
yield a non-negative expected net profit.
Melitz – Ottaviano (2008): Open Economy
Melitz-Ottaviano (2008): Export Decision & Trade
 
Liberalisation ( in )
 Quantitative Predictions of These Models
•  
Productivity is drawn from a Pareto Distribution for some advantages:
• Ex-post distribution of firm productivity conditional on survival also has a Pareto
Distribution.
• Firm size and variable profits (these are power functions of random Pareto
distributed firm-specific productivity) are also Pareto distributed, albeit with
different shape parameter.
Consequently, we obtain closed-form solutions for the survival productivity (or
cost) cut-offs.

With these assumptions, Trefler (2004), Lileeva and Trefler (2010) utilised the
Canada-US FTA of 1989; along with rich plant-level dataset for Canadian
Manufacturing Industry.
Source: Lileeva and Trefler (2010)
••  Labour productivity is used as a proxy for or .
• The change from pre- (‘80-’88) to post- CUSFTA (‘88-’96) in the productivity distribution of Canadian

manufacturing firms in 2nd diagram of the left panel. [Note that this panel reflects the productivity levels of new entrants
to Canadian manufacturing both for the pre-agreement period (1980–1988) and for the period immediately after the agreement came into
force (1988–1996)]:

– fall (leftward shift) in the survival productivity/cost cutoff (measured by entry rate, since it’s NOT appropriate to measure
by exit rate. Why?)
– a striking decline in the entry rates of plants with productivity near or below the median (i.e. around 0) from pre-FTAs.
many low-productivity plants made the cut and joined the team in pre-FTA while in post-FTA a number of such low-
productivity plants no longer made the cut.
– shows that those who start exporting after CUSFTA are indeed among the most productive of those who never exported
before.
• The right panel shows clearly that the distribution for exporters is to the right of that for non-exporters.
On average, Canadian exporters are 40% more productive than non-exporters in the same industry
(Baldwin and Gu 2003).
 NOT Reverse Causality…
• IV can be used (“plant-specific” tariff-cut) or perhaps ‘better’ approach is to
estimate the local average treatment effect (LATE) as done by Lileeva and Trefler
(2010).
• This is the effect on productivity of starting to export for those plants that
started exporting because of the tariff cuts owing to FTA. This only needs
information drawn from plants that were likely to be affected by the CUSFTA.
• Using this technique, Lileeva and Trefler (2010) showed that CUSFTA caused the
productivity of new exporters to rise by 15.3%...
• Gravity: Under Pareto productivity, sector-level bilateral aggregate trade flows
can be decomposed into an extensive margin (absent in Anderson & van
Wincoop, 2002) and an intensive margin:

• Elasticity of trade flows w.r.t. variable ‘iceberg’ transportation costs

• Elasticity
  of Trade Flows w.r.t. fixed costs of exporting

• In the presence of firm heterogeneity, a reduction in variable trade costs

amplifies the effect on aggregate trade volumes through the additional extensive
margin effect.
• The impact of trade barriers is dampened by the elasticity of substitution and
not magnified by it.
 Refinement of Labour Market Conditions
• The wage bargaining process (after DMP search & matching) implies that wages equal the hiring cost. But that
means in Melitz (2003) and MO (2008) that firms with different productivity levels choose employment levels such
that the additional value created by the marginal worker is the same  the wage rate cannot be different across
firms!!
• However, if cost of posting vacancy is not proportional to the wages, then in presence of some bargaining power of
workers and external economies of scale in the differentiated-product sector, we can expect different hiring costs in
the differentiated-product sector, which varies with the average productivity (Felbermayr et al., 2011).
• Now suppose, both H & F have same hiring costs in homogeneous-product sector but different hiring costs in the
differentiated-product sector, depending on the relative L-market frictions in these 2 sectors.
• Hence, assuming that the countries are identical, except in terms of L-market frictions, the country with higher
relative hiring costs in the differentiated-product sector imports differentiated product on net and exports
homogeneous goods.  A lower cost of hiring in the differentiated sector leads to comparative advantage in
differentiated products. What will be the implications of reduction in iceberg trade costs now?? A potential
direction for empirical research.