Market size and entry in international trade: Product versus firm fixed costs

• Date: 01 November 2019
• Author: Walter Steingress
• DOI: http://doi.org/10.1111/roie.12427
• Published date: 01 November 2019

Rev Int Econ. 2019;27:1351–1370. wileyonlinelibrary.com/journal/roie

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INTRODUCTION

Fixed costs to export create entry barriers that restrict trading opportunities. Larger markets allow

firms to slide down the average cost curve and produce at a more efficient scale. As a result, countries

with a larger market size have more firms entering and their consumers benefit from lower prices and

a greater variety of goods compared with consumers in small markets.

The prevailing view of the literature1

is that fixed costs to export are mainly at the firm level—for

example, advertising a firm brand or setting up a distribution network. Given this cost structure,

multi‐product firms have a cost advantage and dominate international trade. Some (other word here

Received: 24 April 2017

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Revised: 15 May 2019

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Accepted: 19 June 2019

DOI: 10.1111/roie.12427

ORIGINAL ARTICLE

Market size and entry in international trade:

Product versus firm fixed costs

WalterSteingress

Bank of Canada, Ottawa, Canada

Correspondence

Walter Steingress, Bank of Canada, 234

Wellington Street West, Ottawa, ON K1A

0G9, Canada.

Email: wsteingress@bankbanque-canada.ca

Abstract

This paper develops a theoretical framework to infer the na-

ture of fixed costs from the relationship between entry pat-

terns in international markets and destination market size. If

fixed costs are at the firm level, firms take advantage of an

intrafirm spillover by expanding firm‐level product range

(scope). Few firms enter with many products and dominate

international trade. If fixed costs are at the product level,

an interfirm spillover reduces the fixed costs to export for

all firms producing the product. The resulting entry pattern

consists of many firms exporting different varieties of the

same product. Using cross‐country data on firm and prod-

uct entry, I find empirical evidence consistent with product‐

level costs. More firms than products enter in larger markets

offering their consumers lower prices and a greater variety

of goods within the product category.

JEL CLASSIFICATION

F12; F14; F23

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STEINGRESS

than anecdotal) evidence2

suggests an alternative view, in which firms benefit from an externality

between exporters that reduces the fixed costs of exporting for a given product. For example, trade

associations advertise a product to foreign consumers (e.g., association of French wine producers)

or define common product standards to lower technical barriers to trade. In this case, fixed costs are

mainly at the product level, leading to large markets being populated by many firms selling different

varieties of the same product.

This paper develops a theoretical framework to infer the nature of fixed costs from the different

effects they have on entry patterns in international trade. The model suggests that the elasticities

of the number of exporting firms and exported products with respect to destination market size are

informative on the presence of fixed costs at the firm or at the product level. Taking the theoretical

predictions to the data, I find supportive empirical evidence of the view that fixed costs operate mainly

at the product level and induce an interfirm spillover that reduces fixed costs for all firms producing

the product.

To start with, I extend the multi‐product general equilibrium framework of Bernard, Redding, and

Schott (2011) to feature two different scenarios of cost spillovers. The first assumes fixed costs are

at the firm level. In this case, firms take advantage of an intrafirm spillover when introducing their

product(s) in the destination market. The spillover reduces the firm's per‐product fixed cost and gen-

erates economies of scale and scope. In the second scenario, fixed costs are at the product level. The

important difference is that, in this case, firms benefit from an interfirm spillover that lowers the fixed

costs to export for all other firms exporting the same product, similar to the aggregate spillover across

exporters in Krautheim (2012).

In order to allow for zero trade flows as well as variation in the number of exporting firms and

exported products across destination countries, I follow Helpman, Melitz, and Rubinstein (2008) and

assume a truncated distribution. Within this framework, I then derive the elasticity of firm and product

entry with respect to destination market size for both scenarios. With fixed costs at the firm level, rela-

tively more products enter because multi‐product firms have a cost advantage. Their lower per‐product

fixed cost allows them to expand their product range (scope) with market size. In contract, with fixed

costs at the product level, the presence of the interfirm spillover implies that relatively more firms than

products enter once market size increases.

Using bilateral data for 40 exporting countries in 180 destinations, I find that larger markets have

significantly more firm entry than product entry. The average firm elasticity is 0.39, while the aver-

age product elasticity is 0.29. The significant difference holds for a broad set of countries at different

levels of development. Two potential explanations for a higher firm than product entry elasticity are

as follows: either the average number of firms per product increases with market size or the average

number of products per firm decreases with market size. The first effect points to more product va-

rieties in larger markets and is consistent with product fixed costs. The second effect suggests that

multi‐product firms enter in small and large markets. However, in larger markets, multi‐product firms

export fewer products compared with the small market because of more competition from single‐

product firms, as in Mayer, Melitz, and Ottaviano (2014). The results in this paper show that larger

markets have, on average, more firms per exported product and that the average number of products

per firm does not vary with market size.

The fact that the number of firms per exported product increases with market size suggests that

consumers in larger markets will be offered not only more products compared with consumers in small

markets but also products at lower prices and a greater variety of goods within the product category.

The estimated elasticity of 0.1 implies that doubling the destination market size increases the number

of exported varieties per product category by 10%. According to the model, the implied reduction in

the price index of the exported product with an elasticity of substitution of 5 is 56%.3