Success when exporting to richer countries requires upgrading the quality of products, but also of inputs

When firms increase exports, they do other things differently as well. Recent studies have shown that exporting leads firms to produce higher-quality products, to invest in new technologies, to pay higher wages, and to offer better working conditions.1 These changes at the firm level are widely thought to have growth-enhancing effects. For example, the influential Commission on Growth and Development (2008) argues that: “A flourishing export sector is a critical ingredient of high growth, especially in the early stages".

But we do not fully understand why exporting leads firms to behave differently. The most common theoretical explanations emphasise scale effects. If there is a fixed cost of a productivity-enhancing investment — the purchase of a new machine, for instance — then the more units a firm sells, the lower the cost per unit and the more attractive the investment. These explanations predict that the effects on firm behaviour will be driven by the volume of exports, not the characteristics of export destinations.

Another set of explanations emphasises product quality. The products that firms sell in export markets may differ from those that they sell domestically, and may require different technologies, skills, and other inputs in production. This set of explanations encompasses two distinct mechanisms. One, if trade costs are incurred per physical unit rather than per dollar of sales, firms have an incentive to ship higher-quality goods further away. This is an old insight, often illustrated by noting that (for many decades at least) the best apples grown in Washington State were shipped to the East Coast. Two, if richer consumers are more willing to pay more for product quality, firms in poor countries may choose to sell higher-quality varieties in richer countries. In the first of these explanations, the key driver is trade costs. In the second, destination characteristics, income in particular, are what matter most.

Finding the right data

We understand these mechanisms theoretically, but their relative empirical importance is an open question. In our recent research, we were able to draw on uncommonly rich and detailed data from Portugal to try to tease apart the different explanations (see Bastos et al. 2018). Portugal is one of very few countries where it is possible to combine customs records at the firm-product-destination level and prices at the firm-product level, which are necessary for our empirical approach. While Portugal is a middle- or high-income country (depending on which classification scheme one uses), the study is also relevant to lower-income countries, many of which have made exports a policy priority.

A key challenge in evaluating explanations based on product quality is that quality is rarely observed in data, and never (to our knowledge) in a nationally representative dataset of manufacturing firms. Previous research has tended to draw inferences about quality from the prices and quantities of products sold. But firms may adjust prices in different markets (they may set different mark-ups over costs) for reasons that have nothing to do with quality. Instead, we focused on the input prices paid by firms as their mix of export destinations changed. While firms may adjust mark-ups on the goods they produce based on the characteristics of the destination, it is not clear why the prices they pay for inputs would change unless they changed the quality of those inputs.

Establishing causality

We used variation in exchange rates in non-Eurozone countries interacted with initial differences in the composition of export destinations to identify the direction of causality. The idea is that a Portuguese firm that exported to, say, Brazil in an initial year will be more influenced by a change in the value of the Brazilian currency than a firm that did not export to Brazil in the initial year. This is true on average in our data.

Using this strategy, we found a positive, robust, and statistically and economically significant causal relationship between the average income of a firm’s destination markets2 and the prices that it paid for material inputs.  Our findings suggest that firms chose to sell higher-quality products in richer countries, that doing so required purchasing higher-quality inputs, and that this mechanism was at least part of the explanation for the effects of exporting on firms’ behaviour. The empirical patterns  are difficult to reconcile with alternative explanations for the effects of exporting on firm behaviour.

There is also evidence that the total volume of sales, and the distance of destinations, matter for input prices (related to the first two explanations discussed above), but these results only appear in particular econometric specifications and are generally not robust.

Implications for development

Probably the most important implication is that success in world markets (where most demand is from rich countries) requires upgrading the quality of both products (outputs) and inputs. If firms cannot source high-quality inputs locally, they face an uphill climb in upgrading outputs. The policy challenge is to foster upgrading of entire complexes of producers and suppliers, not just of individual leading firms. Tax incentives and other inducements may attract foreign firms temporarily, but sustained industrial development requires a broader base of upgrading firms.

References

Atkin, D., A. K. Khandelwal, and A. Osman (2017), “Exporting and Firm Performance: Evidence from a Randomized Trial,” Quarterly Journal of Economics 132(2): 551–615.

Bastos, P, J Silva and E Verhoogen (2018), “Export Destinations and Input Prices”, American Economic Review, forthcoming.

Commission on Growth and Development (2008), The Growth Report: Strategies for Sustained Growth and Inclusive Development, World Bank Publications.

Bustos, P (2011), “Trade Liberalization, Exports and Technology Upgrading: Evidence on the Impact of MERCOSUR on Argentinian Firms,” American Economic Review 101(1): 304-340.

Tanaka, M. (2017), “Exporting Sweatshops? Evidence from Myanmar," unpublished paper, Hitotsubashi University, March.

Verhoogen, E (2008), “Trade, Quality Upgrading and Wage Inequality in the Mexican Manufacturing Sector," Quarterly Journal of Economics 123(2): 489-530.

Endnotes

[1] See Verhoogen (2008) on quality and wages, Atkin, Khandelwal and Osman (2017) on quality, Bustos (2011) on technology choice, and Tanaka (2017) on working conditions.

[2] We defined average destination income using only the initial income levels of those countries. Therefore, changes in average destination income are driven only by changes in the proportion of exports going to different destinations, not by changes in income levels within destinations.

Globalisation Exports Trade costs Input quality Output quality