Lower tariffs promote quality upgrading of products close to the world quality frontier, but discourage quality upgrading for those far away from it

Firms must produce high-quality goods to be competitive in international markets (Kremer 1993, Grossman and Helpman 1991), but how do they transition from producing low- to high-quality goods? In a recent study, we focus on how tougher import competition affects firms’ decisions to upgrade the quality of their goods (Amiti and Khandelwal 2013). Our results, which we summarise in this column, show that stiffer import competition affects quality-upgrading decisions. For firms already producing very high-quality goods, lower tariffs induce them to produce goods of even higher quality. However, for firms producing very low-quality goods, lower tariffs actually discourage quality upgrading. Ours is the first study to show a significant relationship between import competition and quality.

How to measure quality

A major challenge in these types of studies is how to measure quality. The typical approach is to use unit values – the ratio of the value to the quantity sold – as a proxy for quality. However, the problem with this type of measure is that higher prices don’t always necessarily reflect higher quality. For example, one country may set higher prices than another country because it might have higher wage costs, even if the quality is lower. To allow for this possibility, we use an approach developed in Khandelwal (2010) to measure quality. This methodology assigns a higher quality to products with higher market shares, conditional on prices.

To measure quality, we draw on data from 56 countries that export to the US within the manufacturing sector. These data, which are for the 1990-2005 period, are obtained from the US Census Bureau, which reports values and quantities of trade in highly disaggregated product codes (covering more than 10,000 distinct products). Many studies have found that exporting firms have the highest-quality products, and it’s likely that firms export their highest-quality goods to the US. We define the world quality frontier for each product, for each year, as the maximum quality level among countries that export the product. A product’s proximity to the world frontier is its quality relative to this world maximum. Thus, if a product is of very low quality, its proximity to the frontier will be close to zero; if it’s at the frontier, it will be close to one.

Consistent with our expectations, we find that high-per-capita-income countries export more high-quality products. Figure 1, which plots the proportion of each country’s products at the quality frontier, shows a positive relationship, with high-income countries like Canada exporting a large share of high-quality products to the US. The one outlier we notice in the chart is China – a low-income-per-capita country that exports a large fraction of high-quality goods. This is because China exports many high-quality products that have very little domestic value added. For example, Koopman et al. (2008) show that China’s domestic value added in computers is only 5% value. We show that the results hold with and without China.

Figure 1 Quality leaders, 2005

Source: Authors' calculations.

Import competition

We measure import competition using import tariffs, from the World Bank World Integrated Trade Solution database, for each of the 56 countries in our sample at the HS six-digit level – the most disaggregated data available that are comparable across the world. Tariffs are a good proxy for import competition, as many studies have shown that lowering tariffs leads to procompetitive pressures in the liberalising country by reducing mark-ups and inducing a reallocation of resources to more productive firms. These tariff levels vary considerably across industries, countries, and time. For example, average tariffs in Singapore and Norway were only 5% , whereas they were as high as 63% in Morocco and Pakistan; average tariffs were declining during our sample period.

Main findings

Import tariffs have a significant impact on quality upgrading, but whether they have a positive or negative effect depends on how far away the firm is from the world quality frontier within its industry. The main results are summarised in Table 1. For OECD countries, a 10 percentage point fall in tariffs increases quality growth by 5.6% for those products close to the world quality frontier, but reduces quality growth for those distant from the frontier. Although smaller in magnitude, a similar pattern appears for non-OECD countries, with a 1.3% increase in quality growth for products close to the frontier and a 1.1% decline for those distant from it. These results support distance-to-frontier models developed by Aghion et al. (2009), who provide a clear intuition for these findings. That is, if a firm is close to the world frontier it is in its interest to invest in innovation in order to stay in that top position. However, if a firm is a long way from the frontier, it realizes that even if it invests in costly innovation it still won’t be able to catch up to the firms already at the frontier.

Table 1 Effect on quality growth of reducing tariffs by 10 percentage points

  OECD Non-OECD
Close to world frontier +5.6% +1.3%
Distant from world frontier -4.2% -1.1%

Source: Authors' calculations.

In addition, we show that these effects hold for countries across a large range of income levels, provided that the country has a minimum level of institutional quality. If a country has many other market distortions in place, just reducing import tariffs alone might not achieve the competitive effects. For example, for the effects of tougher import competition to be present, there must be the potential for entry and exit of firms; however, if regulations prevent this from happening smoothly, the procompetitive effects of import competition won’t be realized. We confirm this by showing that the results in the table are only present for countries with high-quality institutions, which we measure using the World Bank’s “Doing Business Survey,” based on a country’s regulatory environment. We find that our results hold for both OECD and non-OECD countries with high institutional quality measures, but not for those with poor business environments.

Conclusion

Exposing domestic firms to foreign competition affects the quality of exports. Importantly, the effect of import competition on quality upgrading depends on the product’s quality relative to that of its competitors: lower tariffs promote quality upgrading of products close to the world quality frontier, but discourage quality upgrading for those far away from it. For these results to hold, a country must have a good business environment.

Editors' note: Reprinted by permission from Mary Amiti and Amit Khandelwal, “Does Import Competition Improve the Quality of Domestic Goods?” Federal Reserve Bank of New York Liberty Street Economics (blog), April 8, 2013.

Photo credit: Rajesh_India @ flickr. 

References

Aghion, P, R Blundell, R Griffith, P Howitt and S Prantl (2009), “The Effects of Entry on Incumbent Innovation and Productivity”, Review of Economics and Statistics 91(1): 20-32.

Amiti, M and A K Khandelwal (2013), “Import Competition and Quality Upgrading”, Review of Economics and Statistics 95(2): 476-490.

Grossman, G and E Helpman (1991), Innovation and Growth in the Global Economy, Cambridge, MA: MIT Press.

Khandelwal, A K (2010), “The Long and Short (of) Quality Ladders”, Review of Economic Studies 77(4): 1450-1476.

Koopman, R, Z Wang and S-J Wei (2008), “How Much of Chinese Exports is Really Made in China? Assessing Domestic Value-Added When Processing Trade is Pervasive”, NBER Working Paper No. 14109.

Kremer, M (1993), “The O-Ring Theory of Economic Development”, Quarterly Journal of Economics 108(3): 551-575.

Tariffs Quality frontier Upgrading Import competition