Firms’ Exporting Behavior under Quality Constraints

Abstract

We develop a model of international trade with export quality requirements and two dimensions of firm heterogeneity. In addition to "productivity", firms are also heterogeneous in their "caliber" — the ability to produce quality using fewer fixed inputs. Compared to single-attribute models of firm heterogeneity emphasizing either productivity or the ability to produce quality, our model provides a more nuanced characterization of firms’ exporting behavior. In particular, it explains the empirical fact that firm size is not monotonically related with export status: there are small firms that export and large firms that only operate in the domestic market. The model also delivers novel testable predictions. Conditional on size, exporters are predicted to sell products of higher quality and at higher prices, pay higher wages and use capital more intensively. These predictions, although apparently intuitive, cannot be derived from single-attribute models of firm heterogeneity as they imply no variation in export status after size is controlled for. We find strong support for the predictions of our model in manufacturing establishment datasets for India, the U.S., Chile, and Colombia. http://deepblue.lib.umich.edu/bitstream/2027.42/64437/1/ipc-88-hallak-sivadasan-firm-exporting-behavior-quality-constraints.pdf

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Electronic copy available at: http://ssrn.com/abstract=1444548
FIRMS’ EXPORTING BEHAVIOR UNDER QUALITY CONSTRAINTS
by
Juan Carlos Hallak *
Universidad de San Andres and NBER
and
Jagadeesh Sivadasan *
University of Michigan
CES 09-13 May, 2009
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Electronic copy available at: http://ssrn.com/abstract=1444548
Abstract
We develop a model of international trade with export quality requirements and two
dimensions of firm heterogeneity. In addition to "productivity", firms are also heterogeneous in
their "caliber" - the ability to produce quality using fewer fixed inputs. Compared to single-
attribute models of firm heterogeneity emphasizing either productivity or the ability to produce
quality, our model provides a more nuanced characterization of firms' exporting behavior. In
particular, it explains the empirical fact that firm size is not monotonically related with export
status: there are small firms that export and large firms that only operate in the domestic market.
The model also delivers novel testable predictions. Conditional on size, exporters are predicted
to sell products of higher quality and at higher prices, pay higher wages and use capital more
intensively. These predictions, although apparently intuitive, cannot be derived from single-
attribute models of firm heterogeneity as they imply no variation in export status after size is
controlled for. We find strong support for the predictions of our model in manufacturing
establishment datasets for India, the U.S., Chile, and Colombia.
JEL codes: F10, F12, F14,
Keywords: Productivity, quality, exports, firm heterogeneity
* Juan Carlos Hallak thanks the National Science Foundation (grant #SES-05550190)
and Jagadeesh Sivadasan thanks the NTT program of Asian Finance and Economics for
supporting this work. We also thank the Center for International Business Education (CIBE) for
support. Part of the research in this paper was conducted by Jagadeesh Sivadasan as a Special
Sworn Status researcher of the U.S. Census Bureau at the Michigan Census Research Data
Center. Support for this research at the Michigan RDC from NSF (ITR-0427889) is also
gratefully acknowledged. Any opinions and conclusions expressed herein are those of the
author(s) and do not necessarily represent the views of the U.S. Census Bureau. All results have
been reviewed to ensure that no confidential information is disclosed. We thank Carlo
Altomonte, Inés Armendariz, Paula Bustos, Mariana Colaccelli, Alan Deardoff, Rob Feenstra,
David Hummels, Jim Levinsohn, Diego Puga, Kim Ruhl, Eric Verhoogen and Federico
Weinschelbaum for their comments and suggestions. We also thank seminar and conference
participants at Berkeley, Columbia, Georgetown, LSE, Michigan, Missouri, Oregon, Oxford,
Princeton, San Andres, San Diego, Santa Cruz, Stanford, The World Bank, UBC, U.
Montevideo, UT-Austin, UTDT, CREI (Spain), ELSNIT (Italy), LACEA (Colombia), NBER
Summer Institute, RIEF (Italy), and UNIBO (Argentina). Santiago Sautua, Bernardo D. de
Astarloa, Xiaoyang Li and Alejandro Molnar provided excellent research assistantship.

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Electronic copy available at: http://ssrn.com/abstract=1444548
1Introduction
Understanding what determines firms’ export behavior and performance is one of the most impor-
tant open questions in international trade. At a policy level, the impressive export performances of
rapidly-growing developing countries (World Bank 1987, 1993) suggests that export growth might
play a key role in helping countries attain high income levels. Also, as governments increasingly
view export development as an important objective that justifies policies aimed at fostering it,
understanding what makes firms export should help enhance the effectiveness of such policies.1
More generally, identifying determinants of firms’ exporting behavior is critical for answering the
question of what determines trade patterns across countries, the field’s core question in the last
two centuries.
While work in international trade has traditionally focused on determinants of trade operating
at the sector level, a growing new literature emphasizes the role played by factors operating at
the level of the firm. In this literature a single attribute, heterogeneously distributed across firms,
is usually modeled as the sole determinant of firms’ ability to conduct business successfully, both
domestically and abroad. This attribute is often modeled as productivity (e.g. Bernard et al.
2003, Melitz 2003, Chaney 2008, Arkolakis 2008), or alternatively as the ability to produce quality
(Baldwin and Harrigan 2007, Johnson 2008, Verhoogen 2008, Kugler and Verhoogen 2008). In
either case the models share the property that the endowment of this attribute perfectly predicts
firms’ revenue (henceforth our measure of firm size) and export status. Moreover, the models
predict a threshold firm size above which all firms export — and below which none do.
Although these models parsimoniously explain the salient fact that exporters tend to be large
(Clerides et al. 1998, Bernard and Jensen 1999), the prediction of a threshold firm size for export,
common to single-attribute models, is contradicted in the data by a large number of “anomalous”
firms. Notable among them are “born globals” — small and recently established firms with a strong
export orientation (Oviatt and McDougall 1994, Rialp et al. 2005), and “local dynamos” — large
firms that are successful in their domestic markets but do not sell abroad (Boston Consulting Group
2008). More generally, the models leave much of the observed relationship between firm size and
export status unexplained. As a preview of the data we will describe later in more detail, Figure
1 plots, for each of the four countries in our sample, the fraction of exporters in each of 40 size
quantiles (defined by industry).2
Though this fraction increases with size, there are still many
1The number of export promotion agencies in the world has tripled in the last two decades (Lederman et al. 2007).
2To be consistent with our model, Figure 1 uses data for differentiated products. Appendix figure A.1 shows a
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exporters among the smallest firms as well as a substantial fraction of firms with no export activity
even among firms at the top of the size distribution.
This paper develops a partial-equilibrium heterogeneous-firm model with endogenous product
quality that can explain the lack of a one-to-one relationship between firm size and export status
observed in these graphs.3The model embeds two sources of heterogeneity: “productivity” is the
ability to produce output using fewer variable inputs — as is typically modeled in the literature;
“caliber” is the ability to produce quality with fewer fixed outlays. Product quality shifts out
product demand but increases marginal costs of production and fixed costs of product development.
Although caliber is the primary determinant of quality choice, productivity also affects this choice
by reducing the impact of quality on marginal costs. Therefore, both caliber and productivity
increase firm’s optimal choice of quality.
We describe and analyze the equilibrium in a trade environment with export quality constraints.
In the presence of these constraints, high-productivity low-caliber firms are large in size, but refrain
from exporting because they find the cost of satisfying the export quality constraint excessively
onerous. In turn, low-productivity high-caliber firms are active in the export market despite being
small.More generally, the model implies that export success might depend critically on firm
capabilities that are not as essential for domestic success.
We first solve for the industry equilibrium in the closed economy and in a benchmark case of
an open economy with no export quality constraints. In both cases, productivity (ϕ) and caliber
(ξ) can be combined into a single “ability” parameter η (η = η(ϕ,ξ)) such that key variables of
interest can be expressed in terms of this scalar parameter. For example, regardless of the particular
combinations of ϕ and ξ, firms with the same value of η have identical revenue, profits, and export
status (though they choose different quality levels and charge different prices). Furthermore, the
model allows for a representation isomorphic to Melitz’s (2003) model. A threshold ability level
(η) determines survival, while another threshold ability level (ηu) determines firms’ participation
in the export market. The isomorphism with Melitz’ model is appealing as it makes the case with
no export quality constraints a transparent benchmark.
Next we analyze the full model, where we assume that firms are required to meet a minimum
quality requirement to export.4Although simplistic, this assumption captures a wealth of evidence
similar pattern including all industries.
3We later discuss alternative dimensions of heterogeneity that could also explain the patterns observed in Figure
1 but not all the remaining predictions of the model.
4A similar assumption is made by Rauch (2007) in a model with homogenous firms.
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suggesting that export success is associated with firms’ ability to satisfy quality constraints.5While
different reasons — discussed later — can be invoked to justify the existence of these constraints, our
aim in this paper is not to identify their particular source but rather to identify their presence by
examining its impact on firms’ exporting behavior.
In the presence of export quality constraints, our model implies that the size of a firm is no
longer sufficient information to infer its export status. In particular, a firm that does not export
(high ϕ, low ξ) might have equal sales revenue as an exporting firm (low ϕ, high ξ). Because
of its high productivity, the former firm can compensate its lack of foreign revenue with higher
domestic sales. This prediction can explain the heterogeneity in exporting behavior within size
groups observed in Figure 1.
While a variety of economic forces different from those we propose here can potentially explain
Figure 1, our assessment of the model’s empirical relevance relies on empirically testing the distinct
set of additional predictions it delivers. In particular, our model predicts systematic differences
between exporters and non-exporters conditional on firm size. Specifically, conditional on firm
size exporters are predicted to produce higher quality and sell at higher prices than non-exporters.
Also, to the extent that production of quality goods requires more intensive use of skilled labor and
capital, exporters should pay higher average wages and be more capital intensive. In sum, the model
predicts conditional exporter premia in quality, price, average wage, and capital intensity. Thus,
in a regression framework with quality, price, average wage or capital intensity as the dependent
variable and size controls, the conditional exporter premia should manifest in a positive coefficient
on an export dummy.
The prediction of conditional exporter premia in our model is conceptually very different from
the unconditional exporter premia predicted by recently proposed single-attribute models with
quality heterogeneity (Baldwin and Harrigan 2007, Johnson 2008, Kugler and Verhoogen 2008,
Crozet et al.2008).In those models, exporters are predicted to be systematically different
5The international management literature widely acknowledges quality as a key requisite to access foreign markets
(e.g. Guler et al. 2002, Gosen et al. 2005). In particular, several studies based on firm-level surveys both in
developed and developing countries (e.g. Weston 1995, Erel and Ghosh 1997, Mersha 1997, Anderson et al. 1999,
Corbett 2005) document satisfying the demands of international buyers as a critical motivation for obtaining quality
management certification (ISO 9000). Studies in international trade, using census or large firm—level datasets, find
that quality strongly influences firms’ ability to export (Brooks 2006, Verhoogen 2008, Iacovone and Javorcik 2008).
Finally, international organizations emphasize the attainment of quality standards as a crucial requirement for export
competitiveness (International Trade Center 2005, World Bank 1999).
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