A well-known prediction in the “new” trade theory is that markups fall with trade liberalization. The reason is that, because larger firms and/or more concentrated industries enjoy more market power, their prices are more responsive to an increase in foreign competition. There are efficiency gains and consumers benefit from cheaper domestically produced and imported goods. However, micro-econometric studies have revealed situations where this prediction fails in practice. For example, one study on India’s trade liberalization shows that changes in marginal costs do not reflect perfectly changes in prices due to variable markups (i.e., there is incomplete pass-through). Moreover, the most likely beneficiaries of trade liberalization are not consumers, but instead domestic Indian firms who enjoy lower production costs while simultaneously raise markups. This type of non-standard outcome has given rise to a literature that evaluates, theoretically and empirically, the distribution of gains from trade liberalization among consumers, importers, exporters, and traders (aka intermediaries) as well as the implications for overall welfare.
One branch of the literature, by building on a search and matching approach, aims to quantify the gains from trade while allowing buyers and sellers to be heterogeneous. One study on Colombia’s footwear industry suggests that the outcome from trade liberalization is more likely to be positive for welfare. This is explained by the entry of Chinese firms into the Colombian market, combined with a reduction in search costs of Colombian traders acting as importers after liberalization. In contrast, a different study shows that there is a loss of aggregate welfare in a country where the exporters’ bargaining power is small with respect to traders. This setting is typical of developing countries with farmers as exporters negotiating with traders from developed countries. The intuition is that there is a trade externality underlying the search friction in goods markets that not only affects the division of surplus between farmers and traders, but also the entry of foreign traders into the market. This, in turn, affects trading prospects of farmers who are not matched to a trader. The loss of welfare occurs because farmers and traders only bargain after they find a match and their negotiations fail to internalize this externality.
Another branch of the literature uses a contracting approach to explore the idea that trade liberalization may induce firms to replace trade barriers with contracts that preclude consumers reaping the gains yielded by market integration. The root of this issue is in the successive markups by exporters and traders that might emerge from an imperfectly competitive market structure (double marginalization). In addition, if products are differentiated, competing traders impose a business-stealing effect on each other, which lowers their profits. Exporters can overcome the inefficiency related to the double marginalization by offering bilateral contracts that specify fixed payments and quantities. If the contract offered is also joint with the competing traders the business-stealing effect can be mitigated. However the outcome may be detrimental to consumers: higher profits with restricted sales imply higher consumer prices. Another study on Colombia finds that after the US-Colombia Free Trade Agreement was signed and American exporters started to enjoy duty-free access to the Colombian market, product prices rose, lower quantities were shipped and the number of trader partners in Colombia was reduced. But because contracting corrects for such inefficiencies the resulting effect on aggregate welfare is unclear.
As micro data become available, researchers will be able to evaluate the distributional implications of contracting and search-and-matching more accurately. These will have the potential to make valuable contributions towards the determination of trade policies that lead to greater aggregate welfare.
Antràs, Pol and Arnaud Costinot (2011) “Intermediated Trade,” Quarterly Journal of Economics, 126: 1319-1374.
Bernard, Andrew B. and Swati Dhingra (2015) “Contracting and the Division of Gains from Trade“, Working Paper.
Eaton, Jonathan, David Jinkins, James Tybout and Daniel Yi Xu (2016) “Two-sided Search in International Markets,” Working Paper.
Raff, Horts and Nicholas Schmitt (2005): “Endogenous vertical restraints in international trade,” European Economic Review, 49 (7): 1877–1889 [working paper]
Rauch, James (1999) “Networks versus Markets in International Trade,” Journal of International Economics, 48: 7-35.
Tybout, James R. (2003): “Plant-and firm-level evidence on “new” trade theories,” In: E. Kwan Choi and James Harrigan (eds) Handbook of International Trade, Blackwell Publishing, Malden.