PRICE, PRODUCT QUALITY, AND EXPORTER DYNAMICS: EVIDENCE FROM CHINA

• Author: Yong Tan,Joel Rodrigue
• DOI: http://doi.org/10.1111/iere.12410
• Date: 01 November 2019
• Published date: 01 November 2019

INTERNATIONAL ECONOMIC REVIEW

Vol. 60, No. 4, November 2019 DOI: 10.1111/iere.12410

PRICE, PRODUCT QUALITY, AND EXPORTER DYNAMICS: EVIDENCE

FROM CHINA∗

BYJOEL RODRIGUE AND YONG TAN1

Vanderbilt University,U.S.A.; Nanjing University of Finance and Economics,China

This article develops a model of heterogeneous firms that endogenously choose prices and product quality

to build demand in export markets. New exporters optimally charge relatively low prices and produce low-

quality goods upon entry. Product quality, prices, and sales increase as demand grows. We structurally estimate

model parameters using Chinese customs data. The estimated incentive to build future demand reduces average

export prices by 0.7% and increases export sales by 4% upon entry. Endogenous demand accumulation causes

estimated export prices, product quality, and sales to grow by 2.2%, 12%, and 79%, respectively, over the

following five years.

1. INTRODUCTION

Determining how firms enter and grow into diverse product markets worldwide lies at the

heart of a number of key economic questions. As formalized in the seminal contributions of

Jovanovic (1982), Hopenhayn (1992), Ericson and Pakes (1995), and Melitz (2003), early models

often mapped firm and industry evolution to a single dimension of firm heterogeneity, namely,

productivity. A number of recent studies, such as Foster et al. (2008) or Roberts et al. (2018)

among others, conclude that a single, cost-based dimension of firm heterogeneity is insufficient

to fully characterize the firm-level decision to enter markets, to set prices, to upgrade product

quality, or to invest. This article extends this literature with two specific objectives. First,

we bridge the above literature with research that examines how firms build market share

over time and develop a theory which posits the origin and evolution of firm-level demand

differences across heterogeneous firms. In this sense, we explicitly model where differences in

firm demand come from and how demand evolves over time and evaluate its implications for

firm export decisions. Second, we use detailed Chinese customs data to quantify our theory’s

ability to explain firm-level export growth and study the impact of trade liberalization across

heterogeneous exporters. Matching Chinese customs data with detailed tariff data across export

markets, we use our structural model to characterize the endogenous response of heterogeneous

Chinese exporters to potential trade liberalization.

This article begins by documenting that differences in past firm performance among Chinese

exporters strongly influence the evolution of their future export sales, export prices, and input

prices. We highlight three robust patterns in our data. First, greater current performance (e.g.,

sales) are strongly associated with greater future sales. Second, Chinese exporters initially enter

new markets at relatively low prices. As firm sales grow, so do firm-level prices. Increasing prices

may be indicative of increasing markups, but it might also reflect changes in product quality

∗Manuscript received January 2016; revised January 2019.

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

Alejandro Molnar, Germ´

an Pupato, Tiefeng Qian, Kamal Saggi, Ben Zissimos, three anonymous referees, and numer-

ous seminar participants. Yong Tan acknowledges financial support from the National Science Foundation of China

(71703067) and the National (Major) Science Foundation of China (18VSJ017). Please address correspondence to:

Yong Tan, School of International Economics & Trade, Nanjing University of Finance and Economics, Nanjing, China.

Email: yongtan econ@163.com.

1911

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(2019) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

1912 RODRIGUE AND TAN

and input costs. Third, consistent with the preceding conjecture, we show that as firms expand

into export markets, the price paid for imported inputs also tends to rise. We interpret this last

finding as suggesting that product quality also potentially improves as exporters gain a foothold

in new export markets. Further confirming our intuition, we show that Chinese exporters tend

to upgrade product characteristics as they grow into export markets.

Given these stylized facts, we build a dynamic model where firms choose export prices and

source quality-differentiated inputs to grow sales in each market and maximize the long-run

profitability of the firm. In particular, the model features an endogenous demand accumulation

mechanism where producers optimally choose prices and product quality that build future

demand stock at the expense of lower current profits. In our framework, firms that sell high-

quality products for a given price tend to have relatively high initial sales. High sales lead to

greater future demand through a mechanism where consumers prefer more recognizable brands.

Firms, in turn, are able to exploit greater residual demand in later years by charging higher prices

and increasing markups. This mechanism is further reflected in steady-state firm dynamics that

are characterized by prices, product quality, markups, and sales that endogenously grow over

time; each of these is relatively low when a new exporter enters a new market and will grow

over time among surviving firms. The model rationalizes how initial firm-specific differences

in efficiency interact with market-specific characteristics to generate differences in pricing and

product quality and, in turn, provides a theoretical motivation for the source and evolution of

firm-level demand heterogeneity.

The model is structurally estimated using data from Chinese firms that export electric kettles,

a quality-differentiated, manufactured product.2Small electric appliances belong to a class of

Chinese exports where there has been substantial growth in export value across a wide set

of export destinations. A second advantage of this industry is that nearly all of the firms in

the electric kettle industry import intermediate inputs, and the sample records detailed input

purchase information among these firms. Following Alessandria and Kaboski (2011), we identify

observable differences in product characteristics and investigate how changes in product quality

evolve as firms grow into export markets. Together these features allow us to study a setting

where we can tractably specify the differences in firm characteristics and market incentives that

influence firm pricing and quality choices across a wide set of export markets. Being specific

about the exact product we study also allows us to match our exporters to the tariff rates they

face in destination markets, use our estimated model to generate counterfactual predictions in

each export destination, and disentangle the margins through which electric kettle producers

respond to changes in policy-relevant trade costs.

We map the parallel evolution of product quality, prices, and sales through time and decom-

pose the impact of static and dynamic incentives on the evolution of firm characteristics across

export markets. Using our preferred estimates, we find that dynamic considerations reduce

firm-level prices and increase firm-level sales upon initial entry into new markets by 0.5%–0.7%

and 4%–5%, respectively. Over time, prices, product quality, and sales endogenously rise. Five

years after entry, prices and product quality are predicted to increase by 1%–2% and 6%–12%,

whereas sales endogenously grow by 39%–68%, conditional on survival. Furthermore, our re-

search suggests that a reduction in tariffs faced by Chinese electric kettle exporters rarely leads

to large reductions in the average export prices of products sold to any export market. Rather,

we find that product quality improves in response to trade liberalization, which mitigates the

price depressing effect of tariff cuts.

Research examining firm and industry export dynamics has regularly found that new exporters

are smaller than established exporters in the same market, although the size gap closes gradually

2Our sample includes electric kettles along with electric coffee makers, tea makers, and other electric appliances

used to heat water. For brevity, we group these together and refer to them simply as electric kettles. Rauch (1999)

classifies these products as differentiated. Electric kettles are likewise classified as relatively differentiated according to

the Gollop–Monahan index reported in Kugler and Verhoogen (2012) and are among the differentiated set of industries

in Fan et al. (2015).

PRICE,PRODUCT QUALITY,AND EXPORTER DYNAMICS 1913

as the firm gains experience in new markets.3A number of recent theoretical contributions

suggest that new exporters are small because demand for their product is low in a given market

due to informational or reputational frictions, among other mechanisms. To the extent that

these frictions diminish over time, demand and firm sales grow, should the firm survive in that

product market. Nonetheless, it remains unclear how firms manipulate product characteristics

and pricing over time to gain a foothold in new export markets, grow sales, and maximize

long-run profits.

This article relies on an extensive literature that describes, documents, and predicts firm-

level input and output quality choices, their relationship with pricing decisions, and the impact

these have on firm profitability. Our framework builds directly on the associated static models

developed by Verhoogen (2008), Baldwin and Harrigan (2011), and Manova and Yu (2017).

Not surprisingly, the theoretical structure captures many of same, well-known cross-sectional

patterns. Allowing current demand to be a direct function of past performance, we show that

this class of models can be extended to capture firm pricing, product quality, and sales dynamics.

The key departure of our model is that the firm’s residual demand is a function of its past market

share in a given destination country. In this sense, our work is also broadly related to papers

that study the impact of external habits on economic behavior as in Ravn et al. (2006), Ravina

(2007), and Gilchrist et al. (2017).

Our model likewise shares intuition with Foster et al. (2016) even though its structure is

substantially different. In both models, new entrants in a given market account for the long-

run impact that current pricing decisions will have on future sales and profits through demand

accumulation. Whereas Foster et al. (2016) focus on the U.S. domestic market, we study the

exporter decisions across a diverse set of worldwide export markets. It is well known that firm-

level turnover in export markets is much higher than that in domestic markets. In our setting,

the static and dynamic pricing incentives diverge across firms with different expectations of

sales and survival. In addition, Foster et al. (2016) focus on a setting where there is little room

for product differentiation, but our work studies firms where product differentiation and en-

dogenous quality upgrading play a central role. In turn, we allow market-level characteristics to

affect the evolution of prices, quality, and the pattern of sales across countries. Our findings are

consistent with Manova and Zhang (2012) who document that not only do larger Chinese ex-

porters produce higher-quality products, but that high-quality producers sell a disproportionate

percentage of exports in relatively wealthy and developed countries.

Similar to the seminal contributions from Eaton and Kortum (2002), Melitz (2003), and Eaton

et al. (2011), our model begins by studying how initial differences in firm productivity lead to ex

post differences in export behavior. Furthermore, our work is motivated by numerous pieces

that extend these frameworks to examine static differences in pricing or markups across firms

and countries (Bernard et al., 2003; Melitz and Ottaviano, 2008; Katayama et al., 2009; De

Loecker, 2011; Kugler and Verhoogen, 2012; Manova and Yu, 2017), firm-level heterogeneity

in demand or product quality (Sutton, 2007; Foster et al., 2008; Hallak and Sivadasan, 2009;

Khandelwal, 2010; Baldwin and Harrigan, 2011; Crozet et al., 2012; Kugler and Verhoogen,

2012; Manova and Zhang, 2012; Gervais, 2015; Hu et al., 2017; Roberts et al., 2018), and the

impact of trade on product quality upgrading (Verhoogen, 2008; Amiti and Khandelwal, 2013;

Fan et al., 2015; Flach, 2016; Eslava et al., 2018).4

Our empirical exercise has several similarities with Roberts et al. (2018). However, there

are at least four substantial differences that largely arise from the manner in which demand

3This finding mirrors that in industrial organization, macroeconomics and finance. See Caminal and Vives (1999),

Klepper (2002), Cabral and Mata (2003), Radner (2003), Fishman and Rob (2003, 2005), Bar-Isaac and Tadelis (2008),

Arkolakis (2010), Luttmer (2011), Dinlersoz and Yorukoglu (2012), Drozd and Nosal (2012), Gourio and Rudanko

(2014), and Perla (2017) for examples.

4The article is also related to papers that examine the role of product quality in international trade, including

Gabszewicz et al. (1982), Flam and Helpman (1987), Feenstra (1988, 1994), Schott (2004), Hummels and Skiba (2004),

Hummels and Klenow (2005), Broda and Weinstein (2006), Brooks (2006), Hallak (2006), Mandel (2010), Khandelwal

(2010), Alessandria and Kaboski (2011), and Hallak and Schott (2011).