FIRM‐LEVEL INVESTMENT AND EXPORT DYNAMICS*

• DOI: http://doi.org/10.1111/iere.12156
• Author: Joel Rodrigue,Youngwoo Rho
• Published date: 01 February 2016
• Date: 01 February 2016

INTERNATIONAL ECONOMIC REVIEW

Vol. 57, No. 1, February 2016

FIRM-LEVEL INVESTMENT AND EXPORT DYNAMICS∗

BYYOUNGWOO RHO AND JOEL RODRIGUE 1

Maeil Business Newspaper, South Korea; Vanderbilt University, U.S.A.

This article characterizes the complementarity between exporting and investment in physical capital. We argue

that new investment allows young exporters to grow faster and survive longer in export markets while reducing their

vulnerability to productivity or demand shocks across markets. We structurally estimate our model using detailed

firm-level data. We find that the choice of cost structure has a large impact on model performance and the estimated

costs of exporting or investment. Using detailed capital and output tariff rates, we quantify the impact of policy change

on aggregate export and investment growth.

1. INTRODUCTION

This article studies the impact of investment in physical capital on firm-level entry, growth,

and duration in export markets. We show that new investment allows young exporters to grow

faster and survive longer in export markets while reducing their vulnerability to productivity

or demand shocks across markets. Consistent with these facts, we develop a model that em-

phasizes that firm-level investment and export decisions evolve endogenously with firm-specific

productivity and export demand shocks. We find that capital adjustment frictions slow down

the firms’ ability to make profits in the export market, which, with mean reverting shocks, de-

creases the value of being an exporter. The model is estimated in two steps. First, we estimate

a model-consistent measure of firm-level productivity that accounts for the role of quasi-fixed

factors of production, such as capital stock, in a context where firms endogenously respond

differential demand shocks domestic and export markets. Accounting for this bias, the produc-

tivity estimates among new Indonesian exporters increase by as much as 15% across industries.

Second, we estimate the model’s remaining structural parameters using firm-level export and

investment data. Allowing firms to endogenously accumulate capital substantially alters the

performance of comparable heterogeneous firms and trade models. For instance, the estimated

fixed export costs are reduced by 90% and have a much smaller impact on export decisions.

Finally, using detailed capital and output tariff rates, we quantify the impact of policy change

on aggregate export growth.

Exporting firms are almost universally found to be larger, more productive, and capital-

intensive and pay higher wages than their nonexporting counterparts. Not surprisingly, numer-

ous countries have pursued development strategies that emphasize export promotion with the

purpose of creating and expanding firms with these desirable characteristics. Although it is

natural to expect new exporters to increase capital holdings as they expand into export markets,

little is known about the nature of firm-level investment dynamics in relation to changes in

export behavior. For instance, how much does investment in new capital affect firm duration

and revenue growth in export markets? Likewise, do capital constrained firms forgo sales on

domestic markets in order to enter new markets abroad? What impact do investment costs have

∗Manuscript received May 2012; revised August 2014.

1The authors are grateful for helpful comments from George Alessandria, Eric Bond, Mario Crucini, Kamal Saggi,

Ben Zissimos, three anonymous referees, and numerous seminar participants. Please address correspondence to: Joel

Rodrigue, Department of Economics, Vanderbilt University, VU Station B #351819, 2301 Vanderbilt Place, Nashville,

TN 37235-1819. E-mail: joel.b.rodrigue@vanderbilt.edu.

271

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(2016) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

272 RHO AND RODRIGUE

on the decision to export? Our aim is to develop a model and estimation strategy to answer

these questions within one coherent framework.

It is well known that firm-level investment in physical capital varies dramatically within nar-

rowly defined industries, and this differential behavior has important implications for aggregate

performance.2Similarly, accounting for investment dynamics has proven particularly impor-

tant for capturing firm exit and asset accumulation in a developing country (Bond et al., 2015).

Although these papers focus exclusively on the domestic market, our model highlights the role

that exports have on encouraging investment and, likewise, the impact of costly investment on

deterring firms from entering and maintaining their presence in export markets.

We find that new exporters vary systematically in their investment behavior and export

outcomes. Using detailed firm-level data from Indonesia, we document that new exporters in-

vest systematically faster than similar nonexporting firms. Further, differences in investment

behavior and capital holdings among new exporters are strongly correlated with survival in

export markets, export revenue growth, and domestic market performance. Specifically, the

endogenous capital adjustment model rationalizes why many new exporters are small (under-

investment prior to exporting), why export revenues grow rapidly over the first few years of

initial exporting (rapid new investment upon initial entry), why domestic revenue grows more

slowly among new exporters (capital constraints), and why there is strong firm-level persistence

in export status (irreversible investment in capital holdings).

Recent contributions by Luttmer (2007) and Arkolakis (2013) argue that firm-level selec-

tion across markets and productivity growth can account for exit, entry, and revenue dynamics

in domestic markets, exports markets, or both. Our model provides an alternative explana-

tion for firm-level selection and growth in new markets, costly investment, and the gradual

accumulation of capital. Riano (2011) and Alessandria and Choi (2014) develop calibrated

models of firm-level investment and exporting in Columbia and the United States, respectively.

Riano (2011) focuses on the impact of exporting on firm-level volatility, whereas the latter

paper studies the effects of tariffs and transport cost reductions in a two-sector dynamic variant

of the Melitz (2003) model. Although closely related, our work specifically targets capturing

the frictions associated with investment in a developing country and the impact that convex

and nonconvex investment costs have on the performance of heterogeneous firms and trade

models. Further, our model and counterfactual experiments emphasize the impact that allow-

ing for capital accumulation has important export and investment growth implications over

time.3

We follow a rich literature studying the impact of firm-level decisions on export dynamics.

Constantini and Melitz (2008), Ederington and McCalman (2008), Atkeson and Burstein (2010),

Lileeva and Trefler (2010), Aw et al. (2011), and Bustos (2011) study the impact of firm-level

innovation on productivity evolution and exporting over time. Similarly, a number of recent

papers recognize the role of increasing marginal costs, often justified by a fixed capital input,

in determining firm-level trade outcomes. For example, Ruhl and Willis (2008), Nguyen and

Schaur (2011), Cosar et al. (2014), Vannoorenberghe (2012), and Ahn and McQuoid (2012)

suggest that allowing for increasing marginal costs is key to capturing sales correlation across

markets or export dynamics.4

Our model links exporting and investment through three mechanisms. First, the return to

investment depends on the firm’s current decision to export. Second, we allow that marginal

2See Doms and Dunne (1994), Caballero et al. (1995), Cooper et al. (1999), and Cooper and Haltiwanger (2006),

among others.

3Moreover, in contrast to Riano (2011), our work highlights the role convex and nonconvex for capital adjustment

costs on investment and exporting, the impact the export demand shocks have on firm-level productivity estimation,

and differences in firm-level outcomes across markets. Alessandria and Choi (2007) argue that “lags in expanding trade

flows are potentially more important for net export dynamics than the costs of entering and continuing exporting.” We

study this aspect of heterogeneous firm trade directly.

4Similarly, Soderbery (2014) presents a model with constant marginal costs and a constant firm-level production

capacity to capture the sales correlation across markets.

INVESTMENT AND EXPORT DYNAMICS 273

costs may depend on the firm’s capital stock and, as such, previous investment decisions. Third,

in an environment where firms incur one-time sunk export costs, current export and investment

decisions depend on the firm’s export history. Investment in capital holdings expands firm

capacity and allows for complex intertemporal trade-offs between endogenous investment and

export decisions. A key distinction between our model and those that precede it is that we

allow firms to make a continuous investment decision instead of simply a binary choice between

investing and noninvesting. Further, our model includes both convex and nonconvex investment

costs and allows us to characterize the extent to which investment frictions deter entry into

export markets.

We structurally estimate the model in two steps. First, we develop a method to consistently

estimate firm-level productivity in this context that can be applied to most firm-level manu-

facturing data sets. Our method emphasizes that ignoring the impact of export market shocks

on domestic performance across firms and time can substantially bias productivity estimates.

A key insight of our method is that we are able to exploit differential export behavior over

time to simultaneously identify firm-level productivity and the shape of the marginal cost

function. We find that new exporters, who are often small and build capital holdings slowly

over time, are often mistakingly characterized as unproductive. Our findings suggest that stan-

dard estimates of firm-level productivity are downward biased for new exporters by as much

as 15%.5In the second step, we structurally estimate the model’s dynamic parameters using

detailed information on firm-level investment and export decisions among Indonesian manufac-

turing firms. The model’s parameters are estimated using indirect inference, and the estimated

model matches average investment and export behavior across heterogeneous firms. We find

that allowing for investment costs drastically reduces the estimated size of export entry costs

by 90%.

Finally, we use the estimated model to study the impact of trade liberalization on aggregate

export and investment behavior. In our first experiment, we use detailed data on the tariff

rates faced by Indonesian exporters in destination markets to evaluate the impact on unilateral

tariff reductions in export markets on firm-level export and investment behavior. We find that

eliminating tariffs in destination markets leads to a 18%–39% increase in aggregate exports

relative to the benchmark model after 10 years. Further, our simulations suggest that the

contribution of new exporters, or the extensive margin of export growth, is very sensitive to

model specification.6In contrast, we find that trade liberalization has a relatively small impact

on aggregate investment since only a relatively small number of large firms export in both the

benchmark and counterfactual experiments.

We also study the impact of reducing tariffs on capital imports. Under the assumption of a

competitive capital market, we find that eliminating tariffs on imported capital has a small impact

on aggregate exports initially, but after 10 years the aggregate export growth rates are 14–16

percentage points higher than the benchmark model. Consistent with the evidence in Manova

(2013), we find that this effect is particularly strong in industries where capital constraints are

most severe. Moreover, after the reduction in investment costs, exporters account for as much

as a 5% of the annual investment growth.

The next section describes the data used in this study and documents the key features of

the data upon which we will base our model. Section 3 presents our model of investment

and exporting, whereas Sections 4 and 5 describe the estimation methodology and present the

results, respectively. The sixth section discusses the policy implications of our work, and the

seventh section concludes.

5In line with Demidova et al. (2012), we argue that failing to account for heterogeneous demand shocks across

markets will likely lead to biased productivity estimates in export-oriented industries. Although numerous papers find

that most new exporters are small and unproductive (e.g., Arkolakis, 2010), we conclude that largely new exporters are

small but very productive.

6The contribution of the extensive margin to aggregate exports is studied in Evenett and Venables (2002),

Hummels and Klenow (2005), Ruhl (2004), Alelssandria and Choi (2007), Kehoe and Ruhl (2013), Arkolakis (2010),

and Alessandria and Choi (2014).