OLP5 3013
POLICY RESEARCH WORKING PAPER        3 063
Trade Liberalization, Firm Performance,
and Labor Market Outcomes
in the Developing World
What Can We Learn from Micro-Level Data?
Paolo Epifani
The World Bank                               Ri! l
Development Research Group                   iI 
Trade
May 2003



A POLICY RESEARCH WORKING PAPER 3063
Epifani reviews the micro-level evidence on the effects of      0 There is evidence of a pro-competitive effect of
trade and investment liberalization in the developing        trade liberalization.
world. He focuses, in particular, on the effects of the         o There is no evidence either of learning-by-exporting
1991 trade reform in India since it provides an exczllent    effects or of beneficial spillover cffects from foreign-
controlled experiment in which the effects of a drastic       owned to local firms active in the same sectors.
trade regime change can be measured. His main findings          o There is evidence, however, of positive vertical
are:                                                          spillovers from foreign direct invcstment.
o There is evidence of trade-induced productivity gains       o There is evidence of skill upgrading induced either
(in this respect, however, India is an exception).            by technology imports or by traee-induced reallocations
o These gains mainly stem from intra-industry              of market shares in favor of plants with higher slcill-
reallocation of resources among firms with different         intensity.
productivity levels                                             ' There is no evidence of trade-induced increases in
o The gains are larger in import-competing sectors.       lbor demand elasticities. But direct cvidence suggests
o There is no evidence of significant scale efficiency     that trade exposure raises wage volatility.
gains. Unilateral trade liberalization is often associated      - There is no evidence of substantial employment
with a reduced scale efficiency.                              contraction in import-competing sectors.
This paper-a product of Trade, Development Research Group-is part of a larger effort in the group to assess the impact
of trade and investment liberalization in developing countries. Copies of the paper are available free from the World Bank,
1818 H Street NW, Washington, DC 20433. Please contact Paulina Flewitt, room MC3-333, telephone 202-473-2724,
fax 202-522-1159, email address pflewitt@worldbank.org. Policy Research Working Papers arc also posted on the Web
at http://econ.worldbank.org. The author may be contacted at paolo.epifani@uni-bocconi.it. May 2003. (68 pages)
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about
developm;zent issues. An obhectve of tbe series is toget the findings out quickly, even if the presentations are less than fully polished. The
papers carry the names of the autthors and should he cited accordingly. The findings, interpretations, and conclz!sions expressed in this
paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executdve Directors, or the
countries they represent.
Produced by Partnerships, Capacity Building, and Outreach



RTade Liberalization, Firm Performance and
Labor Market Outcomes in the Developing World
What Can We Learn from Micro-Level Data?*
Paolo Epifanit
University of Parma and CESPRI-Bocconi University
'This papci is part of the joint Centro Studi Luca d'Agliano-World Bank proje(t "Trade, technology diffusion
aud performnauce ini Indian iuaiiufacturtng" I haive benefitecl from thc coniments of Francesco Daveri, Anna Falzoni,
Rocdolfo Helg, Gianniarco Ottaviano, AlessancIra Tutcci aud Alebsan(lro Turrini I am especially gratefuil to Giorgio
Barba Navaretti for helpful dibcitbsion anid advise The uisuial caveat applies
tColrespondlelice UTnversitA Conimucrciale L Bocconi, via Sarfatti, 25 - 20136 Milano (Italy) Phone +39 02
58363378 Fax +39 (12 58363399 E-imail paolo opifamCimni-bocconi it






1 Introduction
In the last decades, many developing countries (e g, Chile in the late 1970s, Turkey in 1983, Mexico
in 1985, Colombia in 1990-91, India in 1991) have undergone a deep economic transformation which
has involved a process of dramatic trade hberalization. This paper reviews the main erhpirical
studies using firm and plant-level panel data to investigate the effects of trade reforms on firm
performance and labor market outcomes in developing countries. We discuss, in particular, the
effects of the 1991 trade reform in India, since it provides an excellent controlled experiment in
whuch the effects of a drastic trade regime change can be measured
The allocative efficiency argument for free trade has been extensively debated by the traditional
trade theory in the context of perfectly competitive markets Since the late 1970s, however, the
so-called new trade theory has shown that the gains from trade originating from specialization
according to comparative advantage are only part of the story, since in the presence of imperfectly
competitive markets trade liberalization can bring additional gains by reducing the deadweight
losses created by domestic firms' market power. In particular, it has been argued that trade liber-
alization, by increasing competition, forces firms to lower price-marginal cost mark-ups and hence
move down their average cost curves, thereby raising firm size and scale efficiency. Recently, it
2



has also been shown that in the presence of within-industry firm heterogeneity, trade liberalization
causes more productive firms to expand at the expense of less efficient firms (which either shrink
or exit), thereby inducing additional efficiency gains Moreover, trade and investment liberaliza-
tion may foster technology advancement and productivity growth in developing countries through
several channels, such as technology advancement embodied in imported capital goods and interme-
diate inputs, technology transfers accompanying foreign direct investment, learning-by-exporting
effects, etc.
In the last decade, a number of empirical works have resorted to firm and plant-level panel
data to see whether the predicted gains from trade liberalization have materializedi in some recent
episodes of drastic trade reform in the developing world. Most of these studies find that trade reform
in developing countries was indeed accompanied by productivity growth, technology advancement,
falling mark-ups and a reshuffling of resources toward the more efficient firms, although in some
cases the evidence may fail to convince because of the hurdles involved in the methodology used
in these studies. This is true, in particular, for India, where in some cases studies using slightly
different methodologies find opposite results. However, aside from methodological issues, India
seems an exception with respect to other trade liberalizing developing countries, since most studies
find that the 1991 trade reform was in fact accompanied by a reduced productivity growth. One
explanation for this result is that India is still a heavily regulated economy, and hence the expected
benefits of industrial restructuring and of the trade-induced reallocation of resources are probably
smaller and will take longer to materialize.
Although the efficiency argument for trade liberalization has generally been accepted, the main
argument against trade reform in the developing countries that have opted for ar import substi-
tution industrialization strategy has often been that trade liberalization would exacerbate income
inequality and hence deteriorate the conditions of the poor. In particular, concerns regarding higher
unemployment among workers displaced by the contraction of import competing sectors, greater
uncertainty and precariousness of job conditions, and the creation of new job opportunities only
3



for the most qualified segments of the workforce have often been deemed inevitable consequences
of trade liberalization.
In this respect, the traditional trade theory (which removes, by assumption, uncertainty and
unemployment) should have been reassuring, since its most celebrated theorem (the Stolper-
Samuelson theorem) predicts that a skill-poor developing country opening up to international
competition will experience a reduction in wage income inequality However, the empirical evi-
dence contradicts this prediction, since it shows that the recent episodes of trade liberalization in
developing countries are generally accompanied by a dramatic increase in wage inequality The
recent theoretical and empirical literature can explain this puzzling evidence, since it shows that in
the presence of imperfectly competitive markets, increasing returns to scale and firm heterogeneity,
trade hberalization can indeed exacerbate wage inequality even in a skill-poor developing country
Plant-level evidence also shows that trade reforms in developing countries do not generally
bring a sharp contraction of import competing skill-intensive sectors. Further, the evidence shows
that trade exposure is associated with a greater wage volatility, but also with a greater investment
in technology and human capital This evidence, too, can generally be explained by trade models
based on increasing returns to scale and imperfectly competitive markets.
A few recent papers address related issues from different perspectives. Harrison and Hanson
(1999) focus on three empirical issues concerning the impact of trade reform First, they address
the question of the weak econometric link between trade policy and long-run growth, and argue
that it may be due to the fact that, because of the lack of data, trade policy cannot yet be
measured adequately The second and third issues addressed by the authors are the small impact
on employment and the large Impact on wage inequality of trade reforms in developing countries
We will mention their results on these topics in the second part of the paper Matusz and Tarr
(1999), and Bacchetta and Jansen (2001) survey the evidence on the adjustment costs of trade
liberalization They show that the overwhelming majority of the studies find that adjustment
costs are small in relation to the benefits of trade liberalization Finally, Tybout (2001) reviews
4



the plant-level evidence in the light of the new trade theory. Our work is complementary to
his, since our review also extends to the effects of trade reforms on the labor markcets and, most
important, it provides a more extensive treatment of the theoretical foundations of empirical work.
The paper is organized as follows. Section 2 illustrates the theoretical predictions concerning
the effects of trade liberalization on firm performance. Section 3 discusses the relevance of these
effects for trade liberalizing developing countries in the light of the micro-level evidence. Section
4 reports the plant-level evidence on the impact of trade liberalization on learning and technology
diffusion. Sections 5 and 6 examine the labor market outcomes of trade liberalization Section 7
analyzes the effects of the 1991 trade liberalization in India. Section 8 concludes.
2    Thade Uleralbe        atio    and ISr PeirarmT              cze
When markets are imperfectly competitive, trade liberalization may affect firm-level variables, such
as mark-ups, size and productivity This section illustrate these effects, while the next reviews the
plant-level evidence on their empirical relevance.
To see how trade liberalization can affect firm performance, first consider a simple setting
with representative firms 1 Next we will show that more can be learned by alloving for firm
heterogeneity. Consider then n identical firms competing d la Cournot in a sector producing a
homogeneous good. Aggregate demand has a constant elasticity a. Technology features plant-level
scale economies and is summarized by the following total cost function.
TC    = f  1 q                                 (1)
where q is firm output, f is a fixed overhead cost and 1/40 is a constant marginal cost. Both f and
1/0 are in terms of labor, the only production factor, chosen as numeraire. Profit maximization by
TiTIs vxa,uple (Iraws on Markusen (1981). Sunilai results indei different abbumuptions about nmarket struc.ture
(an be foiind iu Krugman (1979) ancd Helpmuan and Krugman (1985)
5



individual firms (taking the output of rivals as given) implies the following mark-up pricing rule
_ _ _ _  -(2)
an-1 ,(
Equation (2) is crucial for understanding the pro-competitive effect of trade liberalization. It shows
that a firm's price-marginal cost mark-up, f,n , depends negatively on the perceived product
demand elasticity, (Tn. Thus, when firms face a fiercer competition due to a rise in the number (n)
of rivals, they perceive a higher demand elasticity and consequently lower their mark-up.
With unrestricted entry, profits (ir) are zero in equilibrium:
7r = (p- /I)q-f = O    => q = fv((an-1)                      (3)
Finally, full employment of labor (L) requires:
L = nl = n(f + q/p)                               (4)
where 1 = f + q/l represents labor employed by each firm. Solving equations (3) and (4) for n
and q gives.
(>f )  ' g f'# [(YL    _ )  1                     (5)
It can be shown that trade integration among countries with similar tastes and technology is
formally equivalent to an increase in the size of the economy, as captured by an increase in L. The
effects on firm performance are straightforward:
1) Equation (5) shows that trade integration (i.e., a rise in L) raises the number of firms n.
From (2), this implies that.firms perceive a higher demand elasticity and hence lower their price
and mark-up. This is the pro-compettttve effect of trade integration
2) Trade integration raises firm size q (see equation (5))
6



3) The trade-induced increase in firm size raises firm productivity (given by q/l) due to a better
exploitation of scale economies. This is the scale effictency gazn from trade integration.
2. I   Tntroducing firm     heteroge neity
The above results have been derived from a setting with representative firms Several reasons
suggests, however, to extend the general equilibrium trade models to allow for firm heterogeneity.
In particular:
1) Recent work inter alta by Roberts and Tybout (1996), Olley and Pakes (1996), Aw, Chen and
Roberts (1997) reports evidence of a significant degree of within-industry plant-level heterogeneity.
Hence, allowing for firm heterogeneity may add an important element of realism to the framework
of analysis.
2) Micro-level empirical evidence shows that exporting firms have different characteristics with
respect to non-exporting firms. In particular, the former are larger, more efficient, more skill-
intensive and pay higher wages (Bernard and Jensen, 1997, 1999; Clerides et al., 1998).
3) Most plant-level empirical studies show that trade-induced productivity gains stemrning from
the reshuffling of resources between plants with different productivity levels are more relevant than
the scale efficiency gains due to a better exploitation of plant-level scale economies (Tybout, 2001;
Tybout and Westbrook, 1995; Pavcnik, 2002). Therefore, trade models based on representative
firms may miss an important mechanism through which trade reform affects the allocation of
resources, aggregate productivity and income inequality.
One of the most rigorous attempts to embed firm heterogeneity into a general equilibrium trade
model is provided by Melitz (2002), who generalizes Krugman (1980) by dropping the assumption
of symmetric firms2. This model provides new insights on the impact of trade liberalization on the
intra-industry reallocation of resources and can help explain the stylized facts mentioned above.
2Althoiigh Krugmian (1980) is a cornerstone of the new trade theory, it is uninteresting (in thQ absence of firm
heterogeneity) fioni the standpoint of the effects of trade liberalization on firn performance The reason is that,
siiic in tlus model firnsb face a constant demnand elastiLity, trade integration hab no effects on firms' ruark-upb, and
ou their size anud pioductivity
7



On the demand side, the model features love for variety, captured by a standard CES util-
ity function, as in Krugman (1980) The production side of the economy is characterized by a
continuum of firms, each producing a different variety. The technology features plant-level scale
economies and is summarized by a total cost function as in equation (1), TC(cp) = f + q/l. The
only difference is that now firms have different productivity levels, indexed by W. Hence, W cap-
tures firm heterogeneity in this model. Firms face a demand curve with a constant elasticity (a > 1
Profit maximuzation imphes the familiar mark-up pricing rule, p(W) =   ' I Firms' profits are
then xr(p) = r(p)/a -f, where r(W) is revenue It can be shown that the ratios of any two firms'
outputs and revenues only depend on the ratio of their productivity levels:
q_(__)  ( W, ) e     (     )   ) A                       (6)
q(~'2)   Y'P2 J  r(W2)   'Pi2J
Equation (6) and the expressions for p(w) and 7r(g) show that more productive firms (i e., firms
with a higher W) are bzgger, charge a lower price and earn hzgher profits than less productive firms.
The equilibrium aggregate price index P is a generalization of the standard price index associ-
ated with a CES utility function:
P = [L   p(P)"-npl(W)d W] TI7(7)
where ji(o) is the equilibrium distribution of productivity levels and n is the equilibrium number
of firms. Using the expression for p(W), the price index can be written as
P =    n p p(b) = n  ee                             (8)
where io is the weighted average of firms' productivity levels. Note that the inverse of the price
index equals real per capita income W (i e, W = P-1) Hence, as in Krugman (1980), both
an increase in the number of available varieties n and in the average productivity , raise real
8



per capita income and welfare. However, while in Krugman (1980) the average o:oductivity is
exogenously given and trade reform can only exert its effects through an increase in n, in this
model o is endogenous and hence it can be influenced by trade integration.
Melitz shows that in the absence of any trade costs, a move from autarky to free trade has
no effect on the distribution of productivity levels and average productivity. In this case, the
effects of trade integration are identical to those predicted by Krugman (1980), i.e., a welfare
increasing expansion in product variety, and firm heterogeneity has no impact on average industry
productivity.
In order to give firm heterogeneity an important role to play, two routes can be taken. One is
to relax the assumption of an exogenously fixed demand elasticity (a) for each variety. The other
is to assume the existence of sunk entry costs into foreign markets.
As far as the former is concerned, (in a separate appendix) Melitz shows that, even in the ab-
sence of any trade costs, firm heterogeneity is crucial for the impact of trade when firms' demand
elasticity endogenously increases with product variety, as in Krugman (1979). In this case, trade
integration among two identical countries expands the variety of products and henca increases the
elasticity of substitution among them. In turn, an increased elasticity of substitution induces a
reallocation of market shares towards more efficient firms and thus generates an aggregate pro-
ductivity gain. The intuition for this result is that a higher elasticity of substitution generates a
premium in terms of market shares in favor of firms charging a lower price, i.e., the more efficient
ones.
The second setting carefully explored by Melitz builds on the assumption of sunkc entry costs
into foreign markets. Melitz refers to the results of empirical studies confirming that firms face
significant fixed costs associated with the entry into foreign markets: "These costs are related to
the fact that a firm must find and inform foreign buyers about its product and learn about the
foreign market. Further, it must adapt its product to foreign standards and set up new distribution
channels in the foreign country".
9



The assumption that exporting firms face a fixed cost of exporting has striking implications 3
In the presence of firm heterogeneity, only the more efficient ones can afford to pay the fixed cost of
exporting Hence, these costs generate a partition of firms into exporting and non-exporting firms
The former sell to both the domestic and the foreign markets, whereas the latter only sell to the
domestic market Hence, this partition of firms implies that exporting firms are larger and more
productive than non-exporting firms, and this is consistent with the plant-level empirical evidence
This setting based on firm heterogeneity and fixed costs of exporting can help explain the effects
of trade liberalization on intra-industry reallocation of resources and aggregate productivity In
particular, it allows to explain the empirical finding that output share reallocations among firms
with different productivity levels are the main source of trade-induced productivity gains. The
intuition is the following. In the trade regime, all domestic firms face foreign competition in their
domestic market, which induces a loss of revenue and market share. For non-exporting firms this
translates into a loss of profits. Among these non-exporting firms, the less efficient incur negative
profits and exit, whereas the other non-exporting firms survive with a lower market share than in
autarky. Conversely, exporting firms expand their market share and profits because their access to
foreign markets more than compensate the loss of revenue in the domestic market. Hence, trade
induces both the exzt of less efficient firms and the reallocatton of market shares towards the more
efficient exportzng firms. Both effects contrbute to an mncrease zn average productivity.
'Iln ection 5 we will see that, as shown by Manasse and Tturrini (2001), the interaction of fixed costs of exporting
itiid fain hLetetugeneity has also striking implications with regard to the effects of tiade liberalization on wage
inie(qiuaihty
10



3    Evidence an         the EFect-       o     ')Fraele libeTLinainc          an o75irm
Perform~ance4
3.1    Evidence on the prc-co=aetitive e0b:ct, of trade 1iHerEal'atlon
The pro-competitive effect of trade liberalization has traditionally been investigated by using
industry-level data. Thls literature exemnes the correlation between trade exposure and price-
cost margins at the industry level, using import penetration rates as a measure of trade exposure.
Empirical studies for industrial countries (see, for instance, Schmalensee, 1989) show a negative
corielation between price-costs margins and import competition, especially when domestic con-
centration is high. This result is consistent with the argument that import competition reduces
profits in industries which enjoy above normal returns.5
As for the developing world, the country studies reported in Roberts and Tybout (1996), relative
to Chile, Colombia, Mexico, Morocco and Turkey, add to the standard industry-level analysis a
study of the correlation between trade exposure and price cost-margins at the plant-level, to see
whether the observed effects at the industry-level Ere common to all producers in an industry or
are concentrated in a subset of producers
3.1.1  Industry-level evidence
As far as the industry-level analysis is concerned, the country studies use the industry-level price-
cost margin to measure industry-level performance. It is immediate to show that, if we assume that
unit expenditures on labor and materials are constant with respect to output, then the price-cost
margin is a monotonic transformation of the price-marginal cost mark-up. The price-cost margin
in industry j at time t, PCM,t, is measured as the value of output (P,tQ,t) minus expenditures
4See also Tybout (2001) on the topics covered in this scetion.
'Usilig a data set coimprisilig 28 indubtries in 42 developed and clevelopmg countries for 18 years, Hoekcian andl
KIce (2003) fihod in a iccent paper that import o:rplctition significantly reduces inciistry mark-upi.
aTlie autilios of the country studies reportedl in Roberts and Tybouit (1996) are J Tybouit for Chile (ch 9), M
Folbcrts foi Colomnbia (ch 10), .1 -M. Grcther for Mexico (cl 11), M Haddad, J. (le Melo and B Horton for Morocco
(clh 12) and F Forouitan for Tuirkey (c1 13)



on labor and materials over the value of output. It equals profits (H3t) plus payments to capital
as a proportion of the industry's value of output:
PCM1, = (fl3t + (rt + 6)K,t) /P,tQ,j                     (9)
where Kt is capital stock, rt is the competitive gross return on capital and 6 is the depreciation
rate Equation (9) shows that sectoral PCMs are influenced by both the rate of profit and the
capital intensity. The country studies use the following basic model:
PCM,t = f (H1t, IMP,t, H,t IMPt, Ktl/Q,t, I,, Tt)              (10)
Here, H,1 is the Herfindahl index, an index of industry structure which is inversely correlated
with the degree of competition among domestic producers. IMP,t is the import penetration
ratio; the pro-competitive effect of trade liberalization should show up as a negative correlation
between the price-cost margin and import penetration. The interaction term H,t- IMP,t tests the
hypothesis that, if highly concentrated industries enjoy above normal profits because of market
power, then they should be more sensitive to foreign competition. Kjt/Q3t is the capital-output
ratio, which controls for sectoral differences in capital-intensity (see equation (9)). Finally, I, and
Tt are industry and time dummies, respectively.
Since most of variation in the panel data used in these country studies is across industries, it
is not surprising that the estimation results crucially depend on whether or not industry dummies
are included in the regression equation When industry dummies are excluded, four out of five
countries studies (i.e., those for Chile, Colombia, Mexico and Morocco) find that the coefficients
of both IMP,t and H,t IMP3t are negative and highly significant. This suggests that import
competition is negatively correlated with sectoral profitability and that the effect is larger for highly
concentrated industries
These results are substantially weakened, however, when industry dummies are included in the
12



regression equation Note that in this case estimated coefficients only reflect temporal variation in
the data, and hence they are better suited to isolate the pro-competitive effect of increased foreign
competition. The country studies show that, when industry dummies are included, evidence of a
significant pro-competitive effect of trade hberalization is found only in Colombia and Mexico
3.1.2  Plant-level evidence
The country studies also examine the pro-competitive effect of foreign competition by looking at
plant-level evidence on price-costs margins. They use the following basic model.
PCM,,= f(S,,t, S,2,,, IMP7t S .,t IMP1t, K3tIQ,I,,Tt)           (11)
where PCM,,t is the price-cost margin of plant i in industry . and time t, S5,t is the share of plant
i's output in sector j's total domestic production, and the other variables in (11) have the same
interpretation as in equation (10). The interaction term S,,t IMP7, tests the hypothesis that
the pro-competitive effect of foreign competition is stronger among firms with a higher domestic
market share.
The coefficient of the linear term S,,t is generally positive and significant, whereas that of the
quadratic term S, is generally negative. This suggests that price-costs margins rise at a decreasing
rate with market shares. More interestingly, in every country studied the coefficients on IMP1t
and S,,, IMP,,, are negative and highly significant, whereas industry dummies do not generally
have any explanatory power. Thus, exposure to foreign competition is associated with lower price-
cost margins, and the effect is concentrated among the large plants. This result suggests that
looking at plant-level evidence highlights a powerful and systematic pro-competitive role of foreign
competition.
13



3.2 Plant-level evidence on trade-induced productivity gains
The literature which uses plant-level data to investigate the productivity gains from trade liberal-
ization shows mixed results. Tybout, de Melo and Corbo (1991) find little evidence of productivity
growth in manufacturing after trade reform in Chile Conversely, Harrison (1994) finds a signif-
icant productivity increase after trade liberalization in Cote d'Ivoire. In section 7, we show that
empirical works using a similar methodology find opposite results with regard to the effects of
the 1991 trade liberalization in India. In this section, we briefly review two recent studies which
will help us clarify the methodological hurdles involved in estimating the effect of trade reform on
productivity.
Tybout and Westbrook (1995) use plant-level panel data to study the efficiency gains induced by
the Mexico trade liberalization. Prior to 1985, Mexico was an inward-looking economy due to heavy
policies of trade protection 7 In 1985, the Mexican government announced its decision to join the
GATT and undertook major reforms leading to a reduction in tariffs by 45% and import licenses by
more than 75% within three years. Hence, the Mexican experience provides an interesting setting
to study the empirical relevance of trade-induced productivity gains in developing countries.
The methodology employed by Tybout and Westbrook allows them to disentangle three poten-
tial sources of productivity gains. The first derives from exploitation of scale economies As shown
in Section 2, trade integration, by increasing the perceived product demand elasticity, causes firms
to loose market power and forces them down their average cost curves, thereby inducing scale
efficiency gains. The second source of productivity gains derives from market share reallocations
among plants with different levels of efficiency As shown in Section 2, in the presence of sub-
stantial firm heterogeneity, market share reallocations can be a relevant source of trade-induced
productivity gains. Finally, the authors include a catch-all residual term which captures changes
in productivity not accounted for by scale effects or share reallocations, such as technical change,
learning-by-doing, externalities, capacity utilization, elimination of waste, managerial effort, and
7The (lata ,isecl by the autlhors are froni Mexico's Annual Industrial Survey and cover the period 1984 throtugh
1990) Thc bsamlple plants iepresent 80% of total oUtput
14



so on. The main findings of Tybout and Westbrook are the following.
a) Scale efficiency effects Most manufacturing sectors show increasing returns to scale, and for
the smallest plants in these industries returns to scale are often relevant (as high as 1 2). However,
the largest plants in these industries generally appear to have reached a minimum efficient scale.
Thus, given that large plants account for a disproportionate share of sectoral output, industrial
expansion does not induce large gains in scale efficiency. More precisely, the mean output growth
was more than 50% in the period 198&1990. But despite this substantial output growth, the
exploitation of scale economies accounts for only the 0.55% rise in average productivity. These
results suggest that the focus of trade models with imperfect competition and representative firms
on the gains from scale economies exploitation may be somewhat misplaced, since these gains
appear modest in magnitude.
b) Output share reallocatzons. This effect accounts for more than 1% rise in average productivity
Although this figure is quite modest, it suggests that output share reallocations among firms
with different productivity levels mighit be empirically more relevant than scale efficiency effects,
and hence that firm heterogeneity can be a key determinant of the efficiency geans from trade
liberalization
c) Residual effect. Most of the average increase in productivity comes from the cetch-all residual
effect, which accounts for 9.6% rise in average productivity. This implies that most of the estimated
overall efficiency gains (11 16%) are indeed left unexplained.
The above results must be interpreted with caution, because of the hurdles involved in the
methodology used by Tybout and Westbrook, which are common, however, to most analyses
of the efficiency gains from trade liberalization. The main methodological problems involved in
estimating the productivity gains from trade reform can be summarized as follows (see Pavcnik,
2002).
1) Identificatzon of the trade effects In most studies, the identification of trade effects relies on
the comparison of plant productivity before and after a trade policy change. As a consequence,
15



this approach attributes productivity changes originating from other sources to trade policy. To
see how serious this problem can be, note that most studies use data covering only a short time
period after trade reform, which implies that the estimates of productivity growth can be heavily
affected by the cyclical behavior of the economy in the aftermath of the reform. Note, further, that
in some episodes of trade liberalization, a deep economic downturn is often the trigger of these
reforms, and hence productivity gains from liberalization can be underestimated if a prolonged
recession leads to reduced capacity utilization
2) Simultanesty bias Assume that plant i's technology is described by the following Cobb-
Douglas production function:
+          it + e,t; eit = wit + e6                    (12)
J=1
where all variables are in logarithms, y,t is output and x,, is the 7th input. The error term e,t
is composed of a stochastic disturbance e,t plus an unobserved plant-specific efficiency term w,t
Note that, since more productive plants are willing to hire more inputs, the error term e,t is
positively correlated with factor inputs. This implies that OLS estimates (or between estimates,
as in Tybout and Westbrook, 1995) of the production function coefficients are biased upward, thus
involving biased estimates of w,j 8
In some cases (e g, in Harrison, 1994) this problem has been tackled by assuming that the
plant-specific efficiency term is time-invariant, which allows to estimate equation (12) using a
fixed effects estimator. This approach only removes the bias originating from the time-invariant
component of plant-specific efficiency, so it does not solve the problem completely. What is more
worrisome, however, is that this approach, by treating plant-specific efficiency as time-invariant,
also removes the possibility to measure how it evolves after trade reform.
Hence, in general, the simultaneity problem is either neglected or tackled improperly in the
"EbtiLnatteb of Wt, le irn fact. basel on the difference between actuial o,itpnit and oitpiot predicte(d from estimates
of the prod htion fonction coefficients
16



literature.
3) Self-selection bzas. The literature generally neglects the self-selection bias induced by plant
closing  Pavcnik (2002) shows that, under certain conditions, a negative correlation is to be
expected between the efficiency term La,, and capital stock, conditional on surviving plants. This
implies that the estimated coefficient of capital stock in production function (12) is generally biased
downward.
Pavcnik (2002) proposes an alternative methodology which addresses most of these issues In
particular, the problem of identification of the trade effects is addressed by comparing plants' pro-
ductivity growth in the export oriented and import competing sectors with that of firms in the
iion-traded sector The simultaneity ard self-selection biases are addressed by using a semipara-
metric procedure in which the plant-specific efficiency term is modeled as a time-varying function
of capital and investment "
Pavcnik implements her methodology using data on Chilean manufacturing plants for the period
1979 to 1986, i.e, in the aftermath of a drastic trade hberalization. Plants are partitioned into
three groups. Plants belonging to a 4-digit ISIC industry exporting more than 15% of its total
output are characterized as export oriented. Plants belonging to an industry whose ratio of imports
to total output exceed 15% are instead characterized as import competing. The rest of the plants
belong to the non-traded sector.
Pavcnik uses the mentioned procedure to obtair consistent estimates of plants' productivity
growth in each of these groups. The results are striking. In the period 1979-1986, thc productivity
of export oriented plants grew, on average, by 25.4%, that of import competing plants grew by
even more (31 9%), while that of plants in the non-traded sector grew by only 6 2%. These results
suggest a dramatic productivity growth differential in favor of plants exposed to international
competition with respect to inward-oriented plants. They also suggest that, in the case of a
"Siruilarly, a re(eut paper by Fernandez (2002) uses a panel of Colomubian plants from 1977 to 1091 to estimate
pio(luation functionis separately across manufacturing industries These estimates are then used to dcerive plant-level
tilue-varying productivity meastues She finds a btrong negative impact of tradc protection on plant produictivity
17



unilateral trade liberalization (such as the one experienced by Chile), trade-induced productivity
gains can be higher for import competing plants relative to export oriented plants
Pavcnik also uses a procedure similar to that used by Tybout and Westbrook (1995) to dis-
entangle the contribution of output share reallocations among firms with different productivity
levels to productivity growth She finds that in the export oriented sector, average productivity
growth due to output share reallocations equals 16 6%, while the rest (8 7%) is due to within
plants productivity growth The figures for the import competing sector and the non-traded sector
are, respectively, 21 3% and 10 7%, and 2 4% and 3 8% These results strongly suggest that the
reshuffling of resources in favor of more productive firms is a critical determinant of productivity
growth and that, consistent with Melitz (2002)'s model, this effect can be largely due to trade
liberalization ii)
3.3 More on trade policy and scale efficiency
Tybout and Westbrook (1995) also look at patterns of sectoral change in measures of foreign
competition to see whether they are correlated with estimated productivity changes. Correlations
are generally insignificant. The only robust finding is that heightened import competition reduces
scale efficiency. This result seems to contradict one of the main predictions of the simplest models of
the new trade theory (such as the one illustrated in Section 2), i e , that in the presence of imperfect
competition the trade-induced increase in firm size can be an important source of efficiency gains
Indeed, most general equilibrium models based on imperfect competition (see, for instance, Cox
and Harris, 1985) predict that trade liberalization will generate welfare gains primarily through
the mechanism of increased scale
The empirical evidence on the effects of trade liberalization on firm size is mixed Roberts and
Tybout (1991) find that higher import penetration is associated with lower employment per plant
'"Coli.istent with thc,e resildts, uibng data on Brazilian rianifactiring, Miiendiler (2002) finds thilt thle shut-
(II)wii piohl,ality of inefficient firms lises with competition frorii abroad, thiis contributing positively to aiggregate
p1 uod,ct.ivity
18



in Chile and Colombia. Conversely, other works on developed countries find that th-e removal of
tariff protection increases output."1
The theoretical literature emphasizes that the effects of trade policy in the presence of imperfect
competition are generally sensitive to the specific assumptions concerning market structure and
industry characteristics. Following Head and Ries (1999), now we argue that a slight modification
of the simple model illustrated in Section 2 can help explain the finding of Tybout and Westbrook
(1995) that increased import competition may reduce firm size and scale efficiency.
Consider n domestic firms and nt foreign firms competing d la Cournot in an industry producing
a homogeneous good. Domestic and foreign firms employ the same production technology, featuring
a fixed cost f and a constant marginal cost 1/0. Markets are segmented, as in Brander (1981). Let
ri, and rf denote the ad valorem tariffs charged by the domestic and foreign country, respectively
The profits of domestic and foreign firms (-r and 7r', respectively) are given by
7r =   (Ph -l 5)qh + (pf/(1 + rf)-1/1)qf-f                    (13)
7r' =   (pi,/(l + r,,)-1/5)qh + (pf- 1/0)q' -f
Here, ql, and qh denote, respectively, domestic and foreign firms' sales to the domestic market,
whereas qf and qr are domestic and foreign firms' sales to the foreign market, respectively pi, and
pf are the final consumer prices in the domestic and foreign market, respectively.
Since the two markets are segmented (and marginal costs are constant), a firm's choice of
output in one market is independent of its choice of output in the other markcet. Hence we can
concentrate on the domestic market to study the impact of rh on ql, and qh, noting that the impact
of rr on qf is analogous to that of r1, on q'. The first order conditions for profit maximization in
"Sce, foi mitance, Baldwin and Goiecki (1986) and Caves (1984) for an analysis of average plant scale in Canada
anitd Anistialid, respectively
19



the domestic market are given by:
a--r  =  phqh+Ph-1/0=0                                 (14)
87r*  =phql*, + pi, -(1+T,/     0
Totally differentiating equations (14) with respect to qh, qh and rh, using Cramer's rule and
assuming that firms' outputs are strategic substitutes, it is possible to show that:
-   > 0, aq   <0                                 (15)
Inequalities in (15) show that a home tariff raises output per firm in the domestic country and
lowers output per firm in the foreign country. Similarly, a foreign tariff raises output per firm in
the foreign country and lowers output per firm in the domestic country. The intuition is that a
home tariff raises the marginal cost of foreign exporting firms, forcing them to lower output to
raise marginal revenue and restore the equality between marginal cost and marginal revenue. In
turn, foreign firms' contraction allows domestic firms to expand.
To sum up, competition a la Cournot in the context of segmented markets implies that unilateral
trade liberalization by the domestic country reduces firm size and scale efficiency in the domestic
country and raises scale efficiency in the foreign country.'2  This result may help explain why
empirical studies often find that increased import competition due to unilateral trade liberalization
reduces firm size in developing countries
Head and Ries (1999) test the implications of this model using a panel of 230 Canadian 4-digit
SIC industries for the period 1987-1994. The focus of their empirical analysis is on the effects on
firm size of the 1988 Canada-U.S F'ree Trade Agreement, which led to a gradual bilateral tariff
"Head aud Ries (1999) show that this result holds also under the assumption of free entry of firms
20



removal between the two countries Their basic regression equation is:
Ilnqtt = %�+ Pt +yc.'ArCA + zUSrY t + eSt                   (16)
where q,j, is average output per plant in the ith industry at time t, a. and /3t are industry and time
fixed effects, respectively, rCA and rus are the industry tariff rates charged by the Canadian and
U S governments, respectively, and et is an error term. Regression results show that Canadian
tariff reductions lowered plant scale in Canada, while U.S. tariff reductions had the opposite effect.
Both effects are highly significant and quite large in magnitude. For instance, estimated coefficients
imply that the average reduction of Canadian tariffs by of 5.4% caused a 6.1% scale reduction in
Canada, while the average reduction of U.S. tariffs by 2 8% caused a 4 6% scale incre-se in Canada.
An other interesting result is that tariff effects are smaller in industries characterized by high
turnover rates (measured as the sum of entry and exit divided by the number of establishments).
This suggests that plant entry and exit dampen scale adjustments, and hence that industries
characterized by free entry and exit are not much affected by tariff reductions. This result is in
line with results reported by Roberts and Tybout (1991) for Chile and Colombia, showing that the
effect of import penetration on employees per plant decreases with industry turnover.
Head and Ries also look at plant size heterogeneity to examine whether plants belonging to
different size groups show a different response to trade policy changes Their main result is that
only the scale of large plants is responsive to tariff reductions. Conversely, small plants are de facto
insulated from the effects of trade liberalization.13
To sum up, the plant-level evidence illustrated in this section suggests that trade-induced scale
efficiency gains are generally small in magnitude, because: 1) a disproportionate share of industry
output is produced by large firms, which appear to have reached minimum efficient scale; 2) small
plants' output does not respond much to tariff reductions; 3) entry and exit of firms in response
3Simlilarly, Fernandez (2002) finds that, among Colombian firmis, the negative impact of protcetion on produtc-
tivity L8 stionger for large plants relative to small plants.
21



to changing profit opportunities lower the quantity adjustment by incumbent firms in sectors with
high turnover rates The evidence also shows that unilateral trade liberalization generally reduces
firm size and scale efficiency in import competing sectors This is not a worrisome result, however,
since the evidence also shows that, notwithstanding this negative effect, overall trade-induced
productivity gains are higher in import competing sectors.
4 Trade and Technology Advancement
In addition to the static effects illustrated in Section 2, trade liberalization has also been argued
to have other static and dynamic effects, most of which are related to knowledge diffusion and
technology advancement Here we briefly review some of these effects.
Imports of dzfferentiated intermedtate inputs and capztal goods
As first shown by Ethier (1982), in the presence of firm-level scale economies, free trade in
differentiated intermediate inputs is formally equivalent to technical progress. The reason is that
imports of intermediates allow a finer division of labor which increases firms' efficiency A similar
reasoning applies to imports of differentiated capital goods. Further, through imports of inter-
mediates and capital goods, domestic firms can benefit from foreign innovations incorporated in
these goods This argument is particularly relevant for developing countries In a dynamic ex-
tension of Ethier (1982)'s model, Rivera-Batiz and Romer (1991) have also shown that, under
certain conditions (indeed quite restrictive), trade in differentiated intermediates can permanently
increase the rate of innovation and growth 14 Finally, as shown by Lee (1993), if capital goods
are capital-intensive, then trade liberalization reduces the price of capital goods in capital-poor
developing countries, thereby increasing the return to investment and the growth rate of capital
stock in these countries; similarly, trade liberalization reduces the price of imported technology in
developing countries, thereby stimulating technology advancement.
"'See Mtendiler (2002) for a pielinhmnary attempt at evaluating the impact of foreign intermediate inputs on
p1o(hict.ivity (hange
22



Foreign dzrect tnvestment
Foreign investment can generate several benefits for the host country. For instance, it can
finance the expansion of industries in which the domestic country enjoys a comparative advantage.
Further, it can lead to the transfer of knowledge from foreign to local firms. Finally, it can provide
local firms with the critical know-how to break into foreign markets
If foreign entrants possess a better technology, they can foster productivity improvements in the
domestic industry either directly, by raising the productivity of the resources used in production,
either indirectly through knowledge spillovers to local firms As far as the latter effect is concerned,
local firms can learn from foreign firms either by simply observing them, or through turnover of
labor, as employees move from foreign to local firms.
Learning by exporting
It is often argued, mainly on the basis of anecdotal evidence, that there are several channels
through which domestic exporters can benefit from the technical expertise of foreign buyers.'5 In
particular, breaking into foreign markets allows firms to acquire knowledge of international best
practice Further, foreign buyers often provide their suppliers with technical assistance and product
design in order to improve the quality of imported goods. It has also been noted that in some
cases foreign buyers transmit to their suppliers located in low-wage countries the tacit knowledge
acquired from their other suppliers located in technologically advanced countries. Hence, exporting
may foster learning and productivity growth
Aside from these beneficial effects, trade liberalization has also been argued to have potentially
negative dynamic effects for developing countries. These negative effects can be thought of as the
dynamic counterpart to the static gains from specialization based on comparative advantage. For
instance, as shown by Lucas (1988) and Young (1991), in the presence of sectoral asymmetries in
the relevance of learning-by-doing, a developing country which in the free trade regime switches
its production mix toward technologically stagnant sectors may suffer a permanent reduction in
liSee, ?rote, alea, World Bauk (1993)
23



its rate of productivity growth Similarly, Grossman and Helpman (1991) have shown that trade
liberalization can adversely affect the rate of innovation and growth in a human capital-poor
developing country by diverting its resources away from R&D Further, Rodrik (1988) argues that,
if firms invest in superior technology to reduce their costs, then their incentive to invest depends
positively on output. It follows that trade liberalization may reduce the incentive to invest in new
technology for firms belonging to the import competing sectors, since these sectors should contract
after trade hberalization
In the previous section, we have already shown that there is evidence of trade-induced produc-
tivity gains in the developing world, and that these gains are larger for import competing firms
Hence, the available micro-level evidence suggests that the potentially negative effects of trade
reforms are actually offset by their positive effects In section 7, we will report more micro-level
evidence on the effects of trade reform in India In the rest of this section, we discuss the empirical
relevance of some of the mentioned channels of international technology diffusion
4.1   The import channel of technology diffusion'6
In the absence of plant-level studies on the link between imports and productivity growth, here we
briefly discuss the evidence based on more aggregated data Coe and Helpman (1995) is one of the
first attempts to perform a rigorous test of the relevance of imports as a vehicle for the international
transmission of technology Using a sample of OECD countries, these authors ask how much of
a country's total factor productivity can be explained by domestic and foreign R&D activities,
where the latter is crucially defined as the import share-weighted average of partner countries'
R&D activities Coe and Helpman find that both domestic and foreign R&D have a positive and
significant effect on domestic TFP. Further, for small countries (only), the TFP elasticity to foreign
R&D is significantly larger than that to domestic R&D. Similarly, using patent data, Eaton and
Kortum (1996) find that innovations that originate abroad explain more than 90% of productivity
"'See also Barba Navaretti and Tarr (2000) and Keller (2001a) for two recent surveys of interna-
tional trade and technology diffusion.
24



growth of small OECD countries, and that more than half of these innovations originate from only
three countries, i e, the U.S., Japan and Germany 17
Coe, Helpman and Hoffmaister (1997) extend their analysis to a large sample of developing
countries. One important difference is that import shares are computed by considering imports
of machinery and equipment only, since these goods are more likely to embody new knowledge.
Their results strongly suggest that intermediate goods imports raise total factor productivity also
in developing countries Meyer (2001) restricts even further the definition of imports used to
compute import shares by considering machinery only and finds that in this case the TFP elasticity
to foreign R&D in developing countries is twice as large as in the case in which all imports are
used to compute foreign R&D.
A recent paper by Barba Navaretti and Soloaga (2002) looks at the role of imported machines in
transferring embodied technological progress. They use data on unit values of machines exported by
the EU to a sample of neighboring developing and transition countries in Central-Eastern Europe
and in the Southern Mediterranean. Here, unit values proxy for the technological complexity
of machines The authors find that imported machines have a positive impact on total factor
productivity, and that the impact is larger the higher the technological complexity of imported
machines.
The above studies examine the link between '-'FP, R&D and imports at the aggregate level
However, as noted by Keller (2001b), R&D spending is highly concentrated by industry For in-
stance, about 80% of total manufacturing R&D is conducted in only four 3-digit ISIC industries in
OECD countries (chemical products, electrical and non-electrical machinery and transport equip-
ment) Therefore, Keller performs separate regressions for the sample of low-R&D industries and
finds that TFP elasticities are significantly smaller in these industries.
To sum up, preliminary evidence using aggregate data suggests that imports are a highly
relevant channel of international technology diffusion, and that the domestic productivity effect of
17See al,,o S.hiff and Wang (2002) and Schiff and Olarreaga (2002) for an analysis of trnde-related technology
diffilsioll
25



knowledge originating abroad is greater the smaller the size and the lower the level of development of
the domestic country, and the greater both the technology intensity of industries and the complexity
of imported machines
4.2 Foreign direct investment
Haddad and Harrison (1993), Aitken and Harrison (1994) and Harrison (1996) are among the first
to use plant-level panel data to analyze the impact of joint ventures and foreign subsidiaries on
local firms' productivity in developing countries. These studies ask two related questions, namely,
whether foreign firms exhibit higher productivity levels than local firms, and whether knowledge
spillovers from foreign to local firms raise the latter's productivity level Data come from three
developing countries, Cote d'Ivoire (1975-87), Morocco (1985-89) and Venezuela (1983-88). Foreign
firms are defined as all firms with foreign equity that exceed 5% of assets
As far as the performance of foreign relative to local firms is concerned, these studies find that,
consistent with other evidence, foreign firms generally exhibit higher total factor productivity, pay
higher wages and have much higher import and export propensities.'8
A more interesting question is whether local firms benefit from spillovers generated by their
foreign counterparts Aitken and Harrison (1994) test this hypothesis by assuming that, if knowl-
edge is transmitted from foreign to local firms, then the productivity of the latter should be higher
in sectors with a larger foreign presence They use a panel of Venezuelan firms to estimate the
following Cobb-Douglas production function:
log Y,,t = log A,,t + a, log SL,t + a2 log UL,,t + a3 log M,,t + a4 log K,,t  (17)
Here, Y,,t is output of firm i in sector J at time t, A is total factor productivity, SL is skilled labor,
UL is unskilled labor, M is raw materials, and K is capital stock. In order to capture the effect of
8Tlie (evidence on total factor productivity growth is mixed. In particular, only in the case of Venezuela TFP
gi owtli ib hugher for foreign firms The converse is true for Mexico, and the (lifference is insignificant for Cote
( 'Ivoiro
26



foreign presence on local firms' TFP, A is modeled as follows:
log A,t = bi + b2FDI3t + b3D, + b4Dt + e,t                 (18)
where FDI,, is the share of foreign firms (as measured by the share of foreign assets in total sector
assets) in sector j at time t, D, and Dt are sector and time dummies, respectively, and e,t is an
error term. A positive effect of foreign presence on local firms' TFP should show up as a positive
and significant coefficient b2.
Estimation results critically depend on whether or not sectoral dummies D, are included in the
regression. When sectoral dummies are excluded, the coefficient b2 is positive and significant. This
suggests a positive correlation between fbreign presence and local firms' efficiency. The correlation
may be spurious, however, since foreign firms may be attracted to sectors in which local firms
make higher profits. In fact, when controiling for unobserved fixed industry characteristics through
sectoral dummies, b2 turns negative and highly significant. Notice that in this case only temporal
variation in the FDI variable is exploited to estimate b2, which suggests that increased foreign
presence has a negative short-run impact on local firms' productivity. One possible explanation
for this result is that foreign firms reduce the market share of local firms, thereby reducing their
capacity utilization. Another possibility is that foreign firms, by paying higher wages, attract the
best workers, thereby reducing the productivity of local firms.
The above results are broadly consistent with the available micro-level evidence on transition
countries. In particular, Djankow and Hoekman (2000) use firm-level data for the Czech Republic
during the initial post-reform period (1992-1996) to investigate the impact of foreign direct invest-
ment and joint ventures on the productivity of Czech firms They find that both FDI and joint
ventures have a positive impact on TFP growth of recipient firms, although the impact of the
former is greater. This result suggests that parent firms transfer more Inowledge to local affiliates
than foreign firms do to local partners. Further, and most important, Djanlcow and Hoekman find
a large negative overall impact of FDI and joint ventures on the TFP of local firms that do not
27



have foreign partnerships. This negative effect becomes much smaller, however, when only FDI is
considered.
Although the micro-level evidence suggests the absence of positive horizontal spillovers from
FDI in developing and transition countries'9, there is a growing literature providing evidence of
positive vertical spillovers from FDI In particular, as noted by Smarzynska (2002), it is possible
that researchers have been looking for FDI spillovers in the wrong place. The reason is that,
since multinationals have an incentive to prevent any kind of spillovers that would increase the
productivity of their local competitors20, but also want to transfer information to their local
suppliers, FDI spillovers are more likely to be vertical than horizontal in nature. In order to test
this hypothesis, Smarzynska uses firm-level data from Lithuania for the period 1996-2000 She
finds evidence of positive vertical FDI spillovers through backward linkages and no evidence of
horizontal FDI spillovers. Similarly, Blalock (2001) and Kugler (2000) find evidence of positive
vertical FDI spillovers using, respectively, a panel of Colombian and Indonesian firms.
Hence, it is fair to conclude that, while the available plant-level evidence strongly suggests the
absence of positive horizontal FDI spillovers in the developing world, it also suggests that relevant
productivity gains may accrue to developing countries' firms due to the linkages between foreign
firms and their local suppliers.
4.3 Learning by exporting?
The micro-level evidence shows a positive robust correlation between exporting and productivity.
There are two plausible non incompatible explanations for this stylized fact. One is that, as shown
by Melitz (2002) and discussed in Section 2, more efficient firms self-select into export markets
The other is the learning-by-exporting argument, according to which exporting causes efficiency
gains. Two recent papers address the question of the direction of causality. Bernard and Jensen
"The only available micro-level evidence of positive horizontal spillover effects comes from developedl countries
Sev Haskel et al, 200)2, for a bttidy oii UK dlata
2'As Lioted by Simarzynska, this can be achieved thro,igh trade secrecy, or by paying higher wages or by locating
in indtstries or countries where local firms have limilte(d imitative capacities, etc
28



(1999) use data relative to U.S. manufacturing plants for the period 1984-1992 They find that
size, wages, productivity and capital intensity are all higher for exporters relative to non-exporters.
They also find clear evidence that good firms become exporters, since performance is higher ex-
ante for exporters. However, they do not find evidence that exporting improves performance, since
productivity and wage growth are not higher ex-post for exporters relative non-exporters
Clerides, Lach and Tybout (1998) address the same question and reach similar results. They use
plant-level manufacturing data for Colombia (1981-1991), Mexico (1986-1990) and Morocco (1984-
1991) Their approach is based on the idea that, if exporting fosters productivi';y growth, then
the productivity trajectory of exporting firms should change after they break into foreign markets
To test this hypothesis, they estimate econometrically the reduced form of a theoretical model
derived from the hysteresis literature (Baldwin, 1989; Dixit, 1989) which explicitly considers two
possible explanations for the correlation between exporting and productivity, namely, self-selection
and learning-by-exporting
In particular, they estimate, indtistry by industry, by full information maximum likelihood
(FIML), the following two-equations system
.1                 .
=   1 if O.X, t++P,et+EZ'/3n(AVC,t-j)+Eby,t-,+                    (19)
J-I               .7 =1
+7.7,t < 0; and y,t = O otherwzse
1,              .'1              *1.
ln(AVC,t) =    yn + y,ln(et) + EZy[ln(K,,) + E yjln(AVCt-j) + Eyj,'y,. �+v,t(20)
7-1            2J=i               J=i
Equation (19) represents the export market participation decision by plant 2 at time t It is a
dynamic discrete choice equation in which Y,t takes a value of one if the firm d-ecides to export
and a value of zero otherwise Here, X,t is a vector of exogenous plant characte-istics, e, is the
real exchange rate (which proxies for changes in relative prices that are common to all plants), the
summation of the terms AVC,t7 is a distributed lag in the average variable cost (which proxies for
marginal cost), the summation of the terms yt,- is a distributed lag in the participation variable,
29



and ,, is a disturbance.2' This equation allows to test whether, after controlling for plant-specific
characteristics, for movements in industry relative prices and for past export participation decisions,
past realizations of marginal costs are negatively correlated with the decision to break into foreign
markets If this is the case, we can conclude that, ceteris paribus, firms experiencing a productivity
increase (as proxied by a fall in marginal costs) are more likely to be exporters
For all countries and for most industries, FIML estimation results show that the sum of co-
efficients of the distributed lag in marginal costs is negative. Individual coefficients are never
significant, however, (maybe because of the high collinearity among them) and some of them are
positive In sum, these results provide weak evidence in favor of the hypothesis that firms improving
their relative performance self-select into foreign markets.22
Equation (20) allows to test the learning-by-exporting hypothesis. if firms experience cost
reductions after entering foreign markets, then, after controlling for firm-specific differences in
capital stock (KXt-) and in past realization of marginal costs, we should observe a negative
correlation between export experience and marginal costs FIML estimation results show, however,
that the coefficients -y' on lagged export experience are generally insignificant In some cases they
are significant, but with the wrong (positive) sign. Only in a few cases these coefficients are
negative and significant, e.g, in the Moroccan apparel and leather industries.23
In short, these results do not support the learning-by-exporting hypothesis 21 There are several
reasons, however, to be cautious in interpreting the results In particular, since the time span
covered by the data is very short, the econometric analysis can only pick up gains in efficiency
which materialize in the short-run (within three years) Further, even if these gains materialize
immediately (which is quite unlikely, given that learning is a gradual process), in the short-run
they can be offset by the sunk entry costs associated with becoming an exporter. Indeed, sunk
21In Irboth cqlations, the disturbance' are composed of ,,nobserved plant randorn effects plis tranmitory noise
22FIML estimation resuilts also show that, in all countries and all industries, firms with large (apital stocks are
mole likely to become exporters Fiurther, firms with past export experience are more likely to be exporters This
lattel result is conibibtent with the literatuire on hysteresis
2 FIML ebtimationi results of eqiiation (20) also show that firms with a larger capital stock have lower niaiginal
(osts, and that marginal costs ten(d to follow a second order auitoregressive process
24Note, howevei, that inlike the above imientioned works, Kraay (1999) findb evidence of leainuirg-by-exportirig
ufte(ts musilig ai panel of 2105 Cbuiiebe furius fiom 1988 to 1992
30



entry costs may contribute to explain the positive and significant correlation betv.een exporting
and marginal costs found by the authors in some cases. Hence, this evidence simply suggests that
becoming an exporter does not generate short-run efficiency gains 25
M     Thade,9 Tachxology a=d WIage LequalHiy ln Dzvelping
Countries
According to the traditional trade theory, trade liberalization should pose no serious distributional
issues in developing countries. The reason is that, since developing countries are high-skilled labor
scarce relative to industrial countries, their trade-induced specialization in low-skillcd intensive ac-
tivities should increase the relative demand for low-skilled labor, thereby reducing vage inequality
in these countries. This prediction has often been used to argue in favor of trade liberalization
in developing countries, since it would both increase efficiency and lower wage dispersion in these
countries
The empirical evidence on wage inequality in developing countries seems to contradict this
optimistic prediction.2" As shown, inter alia, by Robbins (1996) and Harrison and Hanson (1999),
many developing countries experiencing drastic trade liberalizations in the recent past, such as
Chile, Mexico, Costa Rica and Uruguay, have seen a concomitant mcrease in wage inequality and
a generalized increase in the relative demand for skilled labor (i e, skill upgrading).
This puzzling evidence has stimulated an impressive body of research by way of new explana-
tions of the link between trade and labor markets Here we briefly review the main explanations,
25Also, as correctly noted by the authors, their approach does iiot allow to detect efficiency gains accriiing to
workers in the form of hligher wages, buit that leave average variable costs unchanged
'('The prediLtioll iS based on the simple Stolper-Sainuelson theorem  However, as noted by Tiurrini (2(002), ui a
muore realistic higher (limensional setting, i e , in the prebence of muany countries, sectors and produlctioln factors,
it is hard to disrern empirically in which factor *. cointry is relatively abundant and in which trade conitext that
factor is going to gain fron trade hiberahzation. For instance, Turrim perfornms computable ,enreral eqlillibriuim
simLlations to bhow that the effects of trade liberalization on the relative wage of the unskilled in Latin Ameiica
(ritically depends oil whether or not agricultutre is also liberalized A iu iilar point is madte by Hlalrubon and Hanson
(1999) They argute that the dramatu increaise in wage inequality after the 1985 trade reform irn ?lexico dloes inot
necessauily couitra(lict the Stolpei-Saninelson theorem The retason is that, prior to reform, protection in Mexico was
skewed toward low-bkilledl intensive sectors, and it fell mobt in these sectors after trade reform.
31



focusing on their implications for labor market outcomes in developing countries.
Outsourczng
Feenstra and Hanson (1996) formulate a model with capital mobility and a continuum of pro-
duction activities with different skill-intensities. They show that trade and investment liberal-
ization bring about North-South outsourcing of production activities which are at the same time
unskill-intensive relative to other activities performed in the North, and skill-intensive relative to
activities performed in the South The main implication is that, contrary to the standard two-
sector Heckscher-Ohlin model, trade and investment liberalization increase the relative demand for
skilled labor in both regions, and can thus potentially explain the worldwide increase in the skill
premia
The argument put forth by Feenstra and Hanson is consistent with the main stylized facts
concerning the labor market dynamics in both the developed and the developing world Its empir-
ical relevance deserves further scrutiny, however. As argued, for instance, by Robbins (1996), this
model can be relevant for countries, such as Mexico, that experienced large FDI inflows in the last
decades. It is less so, however, for much of trade-liberalizing Latin America, which did not receive
substantial FDI in the 1980s.
Intra-rndustry trade and wage znequaltty
Dinopoulos, Syropoulos and Xu (1999) are the first to investigate the potential role of intra-
industry trade for wage inequality They build a one sector model which features monopolistic
competition and plant-level increasing returns to scale on the production side, and love for variety
on the consumption side As in Krugman (1979), they assume that the price elasticity of demand
faced by each producer increases with the number of competitors Further, they assume that the
skill-intensity of production increases with firm size. In this model, trade liberalization raises the
number of competitors, which implies that prices fall As a consequence, some firms are forced to
exit, thereby raising the average size of surviving firms The effect of trade on the skill premium
follows immediately from the assumption that firm size is skill-biased This latter assumption finds
32



support in several plant-level empirical studies, e.g., in Idson and Oi (1999), who report that large
firms tend to employ a higher proportion of skilled workers.
Related work by Epifani and Gancia (2002) illustrates a new channel through which intra-
industry trade may increase wage inequality. The authors formulate a two-secto-r general equilib-
rium model which features monopolistic competition in both sectors to show that an elasticity of
substitution in consumption greater than one and higher scale economies in the skill-intensive sec-
tor imply that any increase in the volume of trade, even between identical countries, is skill-biased.
The intuition is simple. Trade expands the market size of the economy, which is beneficial because
of increasing returns. In relative terms, however, output increases by more in the skill-intensive
sector, since it is characterized by stronger economies of scale, and the relative price of the skill-
intensive good therefore falls. With an elasticity of substitution in consumption greater than one,
the demand for skill-intensive goods increases more than proportionally, raising their share of total
expenditure and therefore also the relative wage of skilled workers.
This result implies that, if the skill-biased scale effect is strong enough to overcome the standard
factor proportions effect, international trade will spur inequality even in the skill-poor developing
economies, making the model consistent with the evidence of rising skil1-premia in developing
countries that have experienced trade liberalizations.
The authors also show that physical capital accumulation leads to higher skill premia, and that
the intersectoral mobility of capita: is likely to magnify the effects of trade integration on wage
inequality. These findings are consistent with both the evidence on capital relocation towards skill-
intensive sectors (Caselli, 1999) anc the large literature on capital-skill complementarity (Krusell
et al, 2000).
Manasse and Turrini (2001) are the first to study the effects of intra-industry trade on labor
market outcomes in the presence of heterogeneous firms and workers. They build a one sector
monopolistic competition trade model a l1 Krugman (1980). Production of each variety involves a
constant marginal requirement in terms of a raw input and one unit of skilled labor as a fixed cost.
33



Workers are heterogeneous in terms of skills High-skilled workers produce high quality varieties
and earn higher wages, since quality is valued by consumers Trade liberalization has striking
implications for income distribution. Because of foreign competition, all firms loose market shares
in their domestic market. At the same time, the access to foreign markets represents a concrete
opportunity to expand total sales and profits only for some firms The reason is that access to
foreign markets entails a fixed cost Hence, only those firms whose profits are higher than the fixed
cost of exporting can effectively break into foreign markets As a consequence, high-skilled workers
employed in firms producing high quahty goods see their earnings rise after trade integration.
Conversely, less-skilled workers employed in firms producing only for the domestic market see
their earnings fall after trade integration Thus, the model provides a trade-induced mechanism
of reallocation of resources and increasing wage dispersion which operates at the firm rather than
the sectoral level. Further, it is in line with the plant-level empirical evidence (reported below)
showing that changes in the skill premia are significantly associated with the export status of firms.
Dhade-znduced skill-biased technical change
The main alternative explanation for the worldwide increase in wage inequality is exogenous
skill-biased technical change. It has been argued that technology can be at the root of the in-
crease in inequality because recent innovations in the production process, such as the widespread
introduction of computers, have boosted the relative productivity of skilled workers 27 A recent
literature on dzrected technical change, initiated by Acemoglu (1998, 1999), asks whether the bias
of technological change is endogenous. In these models, innovation originates in the skill abundant
North and is then exported to the South An important implication is that innovation responds
to economic incentives in the North In particular, it is shown that skill-complement innovations
are more profitable in a country relatively endowed with skilled workers This implies that the
skill bias of technological change depends positively on the relative endowment of skilled workers
in the North This result may help explain the puzzling concomitant increase both in the skill
27Sec, uniong others, Autor et al [1Y981
34



premium and in the relative supply of skilled workers experienced by most advanced countries in
the last decades. The intuition is that the increase in the relative supply of skilled workers, which
would ceteris paribus depress the skill premium, strengthens the incentive to skill-complement in-
novations. Under certain conditions (in particular, a high elasticity of substitution between high
and low sldlled-workers) the latter effect prevails and determines a rise in the skill premium in the
North. As far as the South is concerned, since it passively adopts the technology developed for
the needs of the North, it is bound to import more and more skill-complement machines, with a
consequent generalized increase in the relative demand for skilled labor and in the sldll premium.
The literature on directed technical change can also shed light on the relation between interna-
tional trade and the sklll bias of technical change It is shown, in particular, that North-South trade
liberalization, by increasing the relative price of skill-intensive goods in the Norlb, increases the
profitability of skill-complement innovations relative to unskill-complement innovations, thereby
magnifying the skill bias of technical change.
It is worth mentioning two other recent works investigating the link between international
trade and technical choice. Neary (2001) formulates a general oligopolistic equihbrium model
where a reduction in trade barriers encourages more strategic investment by incumbent firms in
order to deter entry. In particular, it is shown that, as the number of competitors in an industry
increases after trade liberalization, each firm has a greater incentive to increase its investment
in order to improve its position in the strategic oligopolistic game. Strategic over-investment by
incumbent firms thus raises the ratio of fixed to variable costs Assuming that fixed investment
costs are skill-intensive relative to variable costs, the model predicts that a move towards free trade
induces a higher sklll premium, a higher ratio of sldlled to unskilled workers in all sectors (i.e., skill
upgrading) and little changes in trade volumes. Hence, the model predicts that trade liberalization
can affect technical change and skill premia even in the absence of significant increases in actual
trade volumes 28
"8There is auother important channel through which trade may increase wage inequality im the presence of
oligopoilstic markets For inbtante, Borja. and Ramney (1995) formullate a model where the tradedl sector ib an
35



In the same vein, Ekholm and Midelfart-Knarvik (2001) develop a model where trade hberal-
ization affects the technical choice of firms and can thus lead to skill-biased technical change They
assume the existence of two technologies one is characterized by a high (skill-intensive) fixed cost
and a low (unskill-intensive) marginal cost, while the other features a low fixed cost and a high
marginal cost It is then shown that the market size expansion induced by trade liberalization
increases the relative profitability of firms characterized by a high fixed cost and a low marginal
cost, thus inducing the adoption of the more skill-biased technology
5.1 Plant-level evidence on the determinants of skill upgrading
5.1.1 The role of imported technology
A recent work by Pavcnik (2000) is one of first attempts to analyze the determinants of skill
upgrading in developing countries She uses data on 4547 Chilean manufacturing plants spanning
the years 1979-1986. Chile represents an interesting setting to study the relation between trade
liberalization and skill upgrading in developing countries since, between 1974 and 1979, most
non-tariff barriers were eliminated and tariff rates were reduced from more than 100% to 10%
Following this drastic trade liberalization, from 1979 to 1986, the share of skilled workers in total
manufacturing employment increased by almost 17%, and the skill premium grew by more than
10%
One possible explanation for these trends is the following. Falling trade and investment barriers
bring about a decrease in the relative price of imported technology in developing countries such
as Chile, thereby stimulating technology adoption 29 If the adoption of new technology is a skill-
intensive activity, then skill upgrading and rising skill prernia may be closely linked to the trade-
induced process of technology advancement
oligopoly and is low-skille(d itensive relative to the rest of the economy Firms and workers share oligopolistic rents
in the tiaided sC(tor In this setting, .n exogenotis increase in imports reduces rents in the oligopolistic se(tor,
thereby ied,in.ng the relative wage of the unskilled  Hence, the trade-induiced( fall of rates of retiurns in highly
o,ii(eiitiatecl and iiiionizecl industries, such as the automobile industry, masy contribute to a worldwide increase in
wage inequality
')Thc evidence reported by Eaton cud( Kortim (1996) confirms that the international diffusion of technology is
signifialitly influenced by the degree of piotectionisrn
36



The data used by Pavcnik provide several plant-level variables to measure technology, such as
imported materials, expenditures on patent use and rights, and expenditures on foreign technical
assistance. All of these technology measures, together with new capital investment, show a dra-
matic increase in the period following trade liberalization. In order to test whether skill upgrading
in Chile was influenced by the process of technology adoption, Pavcnik partitions plants according
to whether or not they used imported materials (or received foreign technical assistance, or used
patented technology) in the years following the trade reform She then studies the distribution of
the wage bill share of skilled workers (which proxies for plants' skill-intensity) for the twso groups
of plants. The results are striking: the distribution of the wage bill share of plants investing in new
technology is markedly right-skewed with respect to that of non-investing firms, which means that
the probability of observing a skill-intensive plant is much higher among plants investing in new
technology. This result suggests that technology adoption is a skill-biased activity, so that plants
endowed with a higher share of skilled worlkers invest more in new technology.
Pavcnik also performs a regression analysis which confirms that technology measures are pos-
itively correlated with the plants' share of skilled workers. However, the correlation disappears
when plant-specific fixed effects are included in the estimating equation. Hence, the evidence re-
ported by Pavcnik does not allow to conclude that plants investing in new technology become
more skill-intensive over time. However, the strong evidence reported in the paper concerning the
skill-biased nature of investment in new technology still helps explain within-industry skill upgrad-
ing, as firms investing in new technology, thanks to their investment, expand their employment
share relative to non-investing firms. In other words, it is the reallocation of resources towards
more skill-intensive plants, rather than plants' skill upgrading, which might explain why industries
become more skill-intensive over time.
5.1.2 The role of exporters
While Pavcnik (2000) focuses on the role of imported technology, a related paper by Bernard
and Jensen (1997) centers instead on the role of exporting plants for skill upgrading and wage
37



inequality.30 Contrary to previous studies on the determinants of skill upgrading in manufacturng,
that analyze within-industry and between-industry shifts in employment using fairly aggregated
data, Bernard and Jensen look at the contribution of individual (exporting and non-exporting)
plants to the aggregate increase in the relative demand for skilled labor. In particular, they ask
whether skill upgrading and the rise in the skill premia stem from within-plants increases in the
relative demand for skilled labor pr from a reallocation of resources toward the more skill-intensive
plants The question is of particular interest since it can shed light on the relative contribution of
trade and technology to the increased demand for skilled labor. More precisely, within-plants skill
upgrading can be mostly attributed to skill-biased technical change, i.e, to changes in production
practices (such as the widespread introduction of computers and related technologies) that have
increased the relative demand for more educated workers. On the other hand, between-plants
employment shifts can be mostly attributed to cross-plants demand shifts, and in particular to
trade-induced demand shifts.
The decomposition performed by Bernard and Jensen reveals that between-plants shifts explain
46% of the total increase in the relative demand for skilled labor and 58% of the total increase in
the skill premium These results stand in sharp contrast to previous studies carried at the industry
level, where the within-industry component explain virtually all of the increase in the relative
demand for skilled labor (Katz and Murphy, 1992; Berman, Bound and Griliches, 1994), and hence
suggest that decompositions based on industry-level data hide substantial within-industry plant
heterogeneity and potentially overestimate the importance of skill-biased technical change.
In order to determine the role of the export status of firms for the dynamics of relative wages
and employment, Bernard and Jensen look at the contribution of exporting plants to the within
and between increases. They find that non-exporters have a within effect on relative employment
21% larger than exporters, whereas the between effect on employment is entirely explained by the
exporters As for wages, the role of exporters is even stronger The within effect on wages is 26%
'41The lata uised by Bernard and Jensen come from U S. manLfactiring plants and cover the period 1973-1987
Samuple plants account foi almost two thirds of total manufacturing employment in the U S.
38



larger for exporters than non-exporters, whereas the between effect on wages is entirely explained
by the exporters. These results suggest that the rise in wage inequality is due to employment
gains at exporting plants, even though skill upgrading is taking place at both exporters and non-
exporters.
Finally, in order to test more directly the role of technology and product demand shifts for labor
market dynamics, Bernard and Jensen regress the within and between components of relative wage
and employment increases on changes in export sales, domestic sales and technology variables, such
as the change in the R&D to sales ratio or in computer investment The main results are that
between-plants changes (both in wages and employment) are strongly positively related to increases
in both foreign and domestic demand, with the coefficient of the former three times larger than
the latter The impact of technology measures on the between components is instead weaker.
These results suggest that the between-plants movements of workers and wages, which are crucial
for the increase in the skill premium, are largely determined by demand shifts across plants and
in particular by export demand shifts. As for the impact of demand increases and technology
variables on the within components of wage and employment increases, it is shown, instead, that
the impact of technology measures is relatively stronger than that of demand increases, confirming
that within-plants skill upgrading is mainly driven by skill-biased technical change.
The main conclusion from the work of Bernard and Jensen is that looking at plart-level evidence
instead of aggregate industry-level data reveals that trade-induced demand shifts are responsible
for substantial relocation of resources across plants, and in particular in favor of exporting plants,
and that this might explain much of the recent increase in wage inequality.
T Tadle and LaTicr ElE-R:i                   astk   ties
In the previous section we have summarized the main findings of the theoretical and empirical lit-
erature on the determinants of the rise in wage inequality in trade liberalizing developing countries
However, the rise in wage inequality is not the only adverse effect of globalization on the welfare
39



of workers A new strand of literature, initiated by Rodrik (1997), argues that there are more
subtle ways through which globalization may reduce the welfare of workers and jeopardize social
stability The main argument, set out informally by Rodrik, is that reduced barriers to trade and
investment exacerbate the asymmetry between groups that can cross international borders and
those that cannot. The former groups, which include skilled workers, professionals and owners of
capital, are freer to take their resources where their reward is highest The latter groups, which
mainly include unskilled workers, are instead tied to their country of origin because they are less
capable of taking advantage of the richer menu of opportunities offered by the global market. The
main consequence is that the demand for large segments of the working population becomes more
elastic, since these workers can be more easily substituted by other workers across national borders.
Rodrik argues that a trade-induced increase in labor demand elasticities has the following
adverse consequences for the welfare of workers: 1) a shift of the incidence of non-wage labor costs
towards labor and away from employers; 2) more uncertainty due to more volatile responses of
wages and employment to any exogenous shock to labor demand, 3) a reduced bargaining power
of workers.
Given the relevance of the labor demand elasticity for the welfare of workers, it is useful to see
more formally how it can be influenced by trade liberalization. As shown by Hamermesh (1993)
and Slaughter (2001), an industry's labor demand elasticity, 77, can be decomposed as follows
77 = [1- sIE + sa                              (21)
where s is the labor share of total industry revenue, e is the constant-output elasticity of substitution
between labor and all other factors of production, and (7 is the industry product-demand elastlcity 31
Equation (21) shows that 97 consists of two parts The first, [1-s]e, captures the substitution effect.
It tells, for a given level of output, how much the mdustry substitutes away from labor towards
other factors when wages rise. The second part, sCr, captures the output effect: higher wages
it equation (21) all the elasticities are defined to be positive
40



imply higher costs and thus a lower demand for an industry's output, which translates into a lower
demand for labor. Thus, both the substitution and the output effects contribute to reduce labor
demand when wages rise. Finally, note that the higher the share s of labor in total cost, the higher
the relative importance of the product demand elesticity for the labor demand elasticity.
Note that trade liberalization can influence the elasticities e and a, and thus also the derived
labor demand elasticity 77. First consider (. As shown in Section 2, trade models based on imperfect
competition generally imply that trade liberalization increases the product-market demand elas-
ticity Consider now the constant-output elasticity of substitution e between labor and all other
factors. Suppose that an industry is vertically integrated with a number of production stages.
With international trade, stages can move abroad either within firms by establishing multinational
corporations with foreign affiliates (as in Helpman, 1984), or by buying the output of those stages
from other firms (as in Feenstra and Hanson, 1996). Trade thus gives access to foreign production
factors either directly through foreign affiliates or indirectly through intermediate inputs. As a con-
sequence, trade and investment liberalization expand the set of factors an industry can substitute
towards in response to higher domestic wages, thus increasing e.
To summarize, trade and investment liberalization can potentIally increase the labor demand
elasticity either by increasing the product-market demand elasticity or by increasing the elasticity
of substitution between labor and all other production factors. Next, we turn to the empirical
evidence to see whether trade liberalization actually increased labor demand elasticities.
6.1   Evidence on patterns in 1ezoar denmad eRasticities
6.1.1 lEndustry-level evidence
The first rigorous attempt to estimate the impact of international trade on labor demand elasticities
is provided by Slaughter (2001). He uses the NBER Productivity Data Base to estimate time series
of labor demand elasticities from 1961 to 1991 for production and non-production workers for U.S
manufacturing overall and for eight manufacturing industries. The estimated elasticities are then
41



regressed on several trade measures to see whether patterns in trade can explain the estimated
patterns in the labor demand elasticities
The main trade measures used by Slaughter include exports, imports or net exports as a share
of shipments, measures of trends in transport costs (e.g., the ratio of c i f import value to customs
import value), measures of outsourcing (e g, the share of imported intermediates), multinational
measures (e.g, foreign affiliate share of U.S. multinationals' total employment), et cetera.
The main findings of Slaughter can be summarized as follows In the period of analysis, the
demand elasticity for production labor has increased in manufacturing overall and in most manu-
facturing industries (in particular, it has almost doubled since the mid-1970s) On the other hand,
there is no sign of an increase over time in the demand elasticity for non-production labor (indeed,
this elasticity has fallen in the last decades)
As far as the effect of trade on production labor is concerned, Slaughter finds that most of his
trade measures have a positive impact on the elasticity of demand for production labor and are
generally statistically significant. The results turn insignificant, however, when time dummies or
a time trend are included in the regressions 32 One possible explanation for the lack of robustness
of trade measures to the inclusion of time controls may be the high collnearity between time and
these trade measures. However, the high statistical significance and robustness of the coefficient
of the time trend suggests that time is picking up some force constantly making production labor
more elastic over time In this respect, it is likely that it is not actual trade that matters, but
rather potential trade. That is, what might matter for labor demand is just the ability to transact
internationally regardless of whether such transactions actually occur Thus, trade might be playing
an important role independent of changes in observables such as trade and foreign direct investment
flows.
Finally, as far as the effect of trade on non-production labor is concerned, Slaughter finds that
many of his trade measures have a negative and significant effect on the elasticity of demand
i 2 Sinilarly, using data from a broad sample of OECD countries, Bruno, Falzoni and Helg (2001) find little impdct
of various trade measures on labor demand elasticities in most of these cotntries
42



for non-production labor, and that, contrary to the case of production labor, these measures are
generally robust to the inclusion of time controls.
6.1.2   Plant-level evidence
Krishna, Mitra and Chinoy (2001) use Turkish plant-level data spanning the course of a dramatic
trade liberahzation to test whether greater openness led to an increase in labor demand elasticities.
Until the early 1980s, the manufacturing sector in Turkey received an extraordinarily high level
of protection the average tariff in 1981 was estimated to be 49% Further, for over half of
the products, tariff equivalent of non-tariff barriers were estimated to be over 100%. An import
liberalization program was announced in December 1983 and implemented soon Efter, leading to
a dramatic fall of both tariff and non-tariff barriers.
Krishna et al use annual data from the Turkish manufacturing census for 10 three-digit ISIC
industries covering all plants in the greater Istanbul area and spanning the years 1983-1986. Eight
of the ten industries saw a dramatic fall in protection after trade reform. The labor demand
elasticity is estimated for each of the tcr industries separately, including firm-specific dummies
to control for firm heterogeneity The main result is that, although most elasticit:cs are precisely
estimated and fall in a reasonable range, estimates of the changes in labor demandl elasticities are
small in magnitude and largely insignificant 33
The failure to reject the nul of no changes in labor demand elasticities is somewhat surprising,
since previous studies using the same date. (e g, Levinsohn, 1993) strongly suggest that trade
liberahzation in Turkey led to substantial increases in product-market demand elasticities From
(21) we know that higher product demand elasticities should have translated into higher labor
demand elasticities. One possible explanation for this contradictory evidence is that labor demand
decisions by firms are subject to several frictions, so that it takes time before changes in product
demand elasticities lead to observable chEnges in labor demand elasticities
iFajozylber arid Maloney (2001) mse plant-levcl panel daita for Chilc, Colombia and Mexico iurosb their periods
of lefoinm to estimate labor demand clasticities ii these countries Their resuilts show little evidence of structural
lbieaks aftei trade reform in these countrieb, and of trade-iiduLed increases in labor deruand elasticities
43



7    Evidence on the Effects of Trade Reform in India
7.1 Salient aspects of trade and investment reforms
Until the late eighties India's economic system was highly regulated, so much to lead some com-
mentators to lump (erroneously, according to Basu and Pattanaik, 1997, p 123) India together with
Russia and China as examples of centrally planned economies In June 1991, following a balance of
payment crisis, a newly elected government manifested its willingness to undertake deep structural
reforms and introduced drastic policy changes in the subsequent years. The main features of these
policy changes can be summarized as follows
The trade pol2cy regime changed abruptly and dramatically. Prior to the reform, it was one
of the world's most regulated and protectionist trade regime, characterized by severe quantitative
restrictions and very high import tariffs. On the export side, there were both export controls and
export incentive schemes. Following the reform, the maximum tariff was reduced from 400% to
150% in July 1991 and still further later to reach 64% in 1994. The average tariff was reduced from
128% to 94% in 1992 and then to 55% in 1994. In 1992, import hcences were abolished except
for a group of sectors mainly producing consumption goods. Export subsidies and controls were
abolished
The industrial poltcy was completely overhauled.34 Most barriers to entry into industries were
removed. Industrial licensing was abolished in almost all sectors. Controls over investment and
expansion by large industrial firms were also relaxed, while the list of industries reserved for the
public sector was drastically reduced.
The forezgn investment policy was also completely restructured Prior to the reforms, India's
policy toward foreign investment was very restrictive Equity participation was limited to 40%,
except in a few high-tech or export-oriented sectors. With the reform, this limit was raised to 51%
and foreign investment was permitted in a much larger number of sectors. Further, the Foreign
34 Sec, %utev ai,a, Jha (2000)
44



Investment Promotion Board was created to stimulate FDI in India and the coun, ry entered into
bilateral and multilateral investment guarantee schemes.
Finally, the exchange rate regzme was restructured The highly controlled regime based on a
chronically overvalued exchange rate was dismantled. In 1992, a dual exchange rate was introduced,
and in 1994 the rupee became fully convertible on the current account. The capital account has
not yet been liberalized. The restructuring of the exchange rate regime was accornpanied by two
substantial devaluations of the rupee However, due to an immediate pass-through to domestic
inflation, the real devaluation of the :upee was less than 7% (annually) in the years following the
reforms.
In the rest of this section, we review the main empirical studies that use firm and plant-level
panel data to investigate the effects of this dramatic trade and investment liberclization on the
performance of Indian manufacturing firms and labor markets.
7.2   T[rade liberalization and flrm performance in JTndian m         ufacturing
Two recent studies, Krishna and Mitra (1998) and Balakrishnan et al. (2000), provide an attempt
at a rigorous test of the effects of trade liberalization on firm performance in Indian manufacturing
Both studies use firm-level data obtained from the Center for Monitoring Indian Economy (CMIE)
In both papers, the empirical analysis draws on the methodology developed by Ilall (1988) and
Harrison (1994), which allows to examine the effects of the 1991 trade liberalization on firms'
mark-ups, productivity growth and the degree of exploitation of returns to scale. Notwithstanding
these similarities, the two papers reach completely different conclusions.
The data used by Krishna and Mitra (1998) spans the years 1986-1993 and cover the following
manufacturing industries: Electronics, Electrical machinery, Non-electrical machinery and Trans-
port equipment. The authors find that in all industries except Electrical machiiery there were
ieductions in returns to scale after 1991. This reduction in returns to scale may reflect an in-
creased exploitation of returns to scale by firms operating at too small a scale prior to the reform.
45



Krishna and Mitra also find evidence of significant reductions in mark-ups in the same industries
in the years following the reform.35 Finally, they find evidence of increases in the growth rate of
productivity (ranging from 3 to 6%) in all industries except Transport equipment. This evidence
suggests that the 1991 trade liberalization in India was associated with a strong pro-competitive
effect leading to falling mark-ups, to an increased exploitation of scale economies and an increased
growth rate of total factor productivity. Notice that these effects are in line with the predictions
of the simple model illustrated in Section 2.
The data used by Balakrishnan et al. (2000) span the years 1988 to 1998 and cover the
following manufacturing industries Machinery, Transport equipment, Textiles, Textile products
and Chemicals. In contrast to Krishna and Mitra (1998), these authors find a 1% fall in the annual
rate of productivity growth in the post-trade liberalization period. Further, they find a slight
increase (rather than a reduction) in returns to scale after the trade reform, although the returns
to scale estimated by these authors for the pre-reform period are much lower than those estimated
by Krishna and Mitra (1998). Indeed, Balakrishnan et al. (2000) find evidence of decreasing
returns to scale, whereas Krishna and Mitra (1998) find evidence of strong increasing returns to
scale in all sectors except Electrical machinery.
Given the substantial overlap between the time periods and industries covered by the data used
in the two studies, the striking differences in the results are likely to be caused by differences in
the methodology used to measure factor inputs and in the econometric strategy. In particular,
Balakrishnan et al. (2000) use the fixed-effects estimator, use instrumental variables to control for
the endogeneity of factor inputs and pool together firms belonging to different sectors In contrast,
Krishna and Mitra (1998) use the random-effects estimator, do not control for the endogeneity of
inputs and perform separate regressions for each sector.
Finally, notice that, similar to Balakrishnan et al. (2000), other works find a reduction in the
rate of productivity growth of Indian firms in the post-liberalization period. Srivastava (2000) uses
''Foi Electrical muachinery, Krishna and Mitra find a slight increase in the mark-up They argue, however, that
iiiirk-up estimates for this industry are httle reliable
46



data for about 3000 Indian companies for the period 1980 to 1997 He finds a decline in the rate
of productivity growth in the 1990s as compared to the 1980s Kumari (2000) uses firm level data
relative to engineering industries (electrical and non-electrical groups) for the period 1985 to 1995.
She finds that productivity growth of engineering firms has declined in the post-reform period as
compared to the pre-reform period
To sum up, contrary to other trade liberalizing developing countries, the available micro-level
evidence does not allow yet to discern the effects of the 1991 trade reform in India on firms' mark-
ups, on the degree of exploitation of returns to scale and on productivity growth. Aside from
methodological issues (see section 3.2), one possible explanation for this lack of positive results
is that India is still a highly regulated economy, and hence the expected beneficial effects of the
trade-induced reallocation of resources will take longer to materialize.
7.3   Trade and technical eintciency of -ar--c-.m         ZuifactuIriLg 27>MS
Parameswarn (2000) uses firm-level data to analyze the evolution of technical efficiency of Indian
firms. The data (obtained from COvIE) span the years 1989 to 1998 and are relative to 640
firms belonging to four industries Electrical machinery, Non-electrical machinery, Electronics and
Transport equipment. In order to estimate technical in/efficiency, the author uses the stochastic
frontier production approach developed by Battese and Coelli (1995), which involves estimating a
production function of the type
Y= f (k., lt,rn,t, t) - u,t + E,t                     (22)
where all variables are in logarithms, and y,t is output of firm i at time t The function f(-)
represents the frontier technology, whose inputs are physical capital (k,t), labor (1,,), materials
(m*t) and time t (to allow the frontier to shift over time) C,t is an error term, and u,t is a non-
negative random variable that captures technical inefficiency Parameswarn asks which variables
affect technical efficiency in Indian manufacturing industries. His main findings are the following.
47



Technical efficiency (-u,t) is positively and significantly correlated with R&D intensity in all
sectors, suggesting that R&D activities may contribute to reduce technical inefficiency of Indian
firms Export intensity has a positive effect on technical efficiency in all sectors except Electronucs,
where it has instead a negative and significant effect on technical efficiency Technology import
intensity has a positive and significant effect on technical efficiency in Electrical machinery and
Transport equipment and a negative and significant effect in the other two sectors The negative
impact of technology imports on technical efficiency in high-tech sectors such as Electronics and
Non-electrical machinery is indeed surprising. Another surprising finding is that in all sectors
technical efficiency is negatively correlated with a time dummy variable which takes a value of zero
up to 1991 and a value of one thereafter Hence, trade liberalization seems to be associated with
an increased average technical inefficiency in Indian manufacturing
One possible explanation for these results is the failure by Indian firms in the adoption and
mastering of new technology Another possible explanation is that trade liberalization may have
changed the kind of technology imported by Indian firms In particular, technology imports may
have shifted away from technology which contributes to profits and productivity within a relatively
short time lag and toward technology which makes a more direct contribution to firms' technological
capabilities but requires a longer gestation lag If this is the case, this shift in the kind of technology
imports may contribute to explain why most studies find that trade liberalization in India is
associated with a reduced productivity growth
7.4 Trade liberalization and R&D effort in Indian manufacturing
Kumar and Aggarwal (2000) use firm-level data for the period 1992-1997 to study the trend and
determinants of R&D activity in Indian manufacturing after trade liberalization. The analysis is
motivated by the concern for the declining importance of R&D activity in India. In particular,
while the proportion of world CDP devoted to R&D has steadily increased in the last decades to
reach 2 5% in the 1990s, the opposite occurred in India, where the proportion of national resources
48



devoted to R&D fell from 0.98% in 1988 to 0.66 in 1097. Since more than 70% of R&D expenditure
in India is financed by the government, much of this downward trend is explained by the fiscal
reform of the 1990s, which drastically reduced investment expenditure and subsidics to firms in
order to reduce the fiscal budget deficit. At the micro-level, the evidence shows different patterns
in R&D expenditure between local firms and MNE affiliates in India. In particular, while in the
1990s the average R&D intensity (the ratio of R&D spending to sales) of local firms is still slightly
higher than that of MNE affiliates (0.854% versus 0.818%, respectively), the trend for local firms is
declining (from 0.868% to 0.831%), while that for MNE affiliates is steadily increasing (from 0.766%
to 0 852%) These trends suggest an increasingly central role of MNE affiliates for technological
upgrading of Indian manufacturing.
The firm-level econometric analysis performed by Kumar and Aggarwal shows that firms' R&D
intensity is positively and significantly correlated with technology imports, outward orientation and
capital goods imports. However, when performing separate regressions for local firms and MNE
affiliates, it turns out that, in contrast to local firms, MNE affiliates' R&D effort is not correlated
with export intensity and capital goods import intensity. MNE affiliates' R&D intensity is instead
positively correlated with their profitability, as measured by the price-cost margin. According to
the authors, one possible explanation for thcse findings is that local firms direct their R&D activity
toward absorption of imported technology and outward expansion. In contrast, given their captive
access to the laboratories of their parents and associated companies, MNE affiliates' R&D effort is
primarily directed toward customization of their parents' technology for the local market in those
activities that are more profitable.
7.5   Employment effects of trade reform :n indiarn mam�uactzr:ng
According to the traditional trade theory, trade liberalization expands the (comparative advan-
tage) exporting sector at the expense of the (comparative disadvantage) import competing sector.
However, this trade-induced sectoral reallocation of resources has no effect on aggregate employ-
49



ment, because of the assumption of factor market clearing. In practice, in the presence of frictions
in the labor market and of a sluggish intersectoral mobility of resources, a drastic trade liberaliza-
tion, such as the one experienced by India in recent years, can reduce employment in the import
competing sector and thus raise the short-run rate of unemployment Indeed, fear of increased
unemployment in the import competing sector has often been the main reason against trade lib-
eralization in developing countries pursuing a development strategy based on import substitution
However, as noted by Harrison and Revenga (1994), contrary to the predictions of the standard
trade theory, most empirical studies find only a modest effect of trade liberalization in developing
countries on the employment level in import competing sectors 3(i
Kambhampati et al (1997) examine the effects of the 1991 trade reform in India on employment
in five import competing sectors 37 They use firm-level data taken from CMIE. The data cover the
period 1987-1993 Similar to the results from previous studies, they find no sigruficant employment
effect of trade reform overall and in each of the five sectors studied. More interestingly, the authors
formulate and test a specific explanation for the lack of employment contraction in the import
competing sectors They argue that, in the presence of imperfect competition, trade liberalization
raises firms' perceived product demand elasticity and hence induces them to lower mark-ups and
expand output Hence, the pro-competitive effect of trade liberalization may involve an increase
in the demand for labor. This effect may partially offset the labor demand reduction in import
competing sectors induced by the forces of comparative advantage 38
In order to test this prediction, Kambhampati et al (1997) estimate the following equation
'It =   )30 + 3iWt + P20.t + I%3kIt + 34m,, + 35D + E,t           (23)
where, 1, w, k and m are the logs of employment, real wage, capital stock and raw materials,
l'Sec, for instance, Raama (1994) oni Uriguay, Revenga (1994) oni Mexico, CGirrie ancl Harrison (1994) oni Moro(lo
See also Hairison andl Hanson (1999) on Mexico ancd Morocco
'7The ive imnport competing sectors are Electronics, Electrical mahinery, Non-electrical machinery, Transport
equipminct andl a se( tor that only includes firms that prodiice Diversified prodiicts
"FiScc also Hariisoin and Hanson (1999) on this point
50



respectively; a is the price-margmal cost mark-up; D is a liberalization dummy, which takes a value
of zero for the years 1991 and before and a value of 1 for the years after; E is a stochastic error.
The regression results reported by the authors, obtamed by using the random-effzct cstimator,
show that, overall and in four of the five sectors studied39, both the real wage and the mark-up
are negatively and significantly correlated with firms' labor demand. This evidence suggests that
when the import competing sectors of a liberalizing country are imperfectly competitive, then the
output contraction in these sectors (and the consequent short-run surge in unemployment) may be
much less dramatic than expected in the light of the traditional trade theory.
7.6   Trade liberalization in lHnia: grPeater uncertainty vers-s a richer
menu of opportunities ?
In Section 6, we have shown that a trade-induced increase in product demand elasticities should
also bring about an increase in the derived labor demand elasticities As shown by Rodrik (1997),
this implies that workers exposed to international competition should face a higher volatility of
wages and employment in response to exogenous shocks to labor demand. Daveri, Manasse and
Serra (2002) argue that trade-induced increases in the volatility of factor prices and employment
are only part of the story, since firms and workers exposed to international competition may also
have a greater incentive to invest in productivity enhancing activities, such as training and effort,
in order to hedge the risk of lower incGmes. The aim of the authors is hence to test the empirical
relevance, in the case of India, of what they call "the twin effects of globalization", i.e, higher
uncertainty versus a richer menu of opportunities for firms and workers involved in international
competition.
The data used by the authors come from a survey of 895 Indian firms belonging to five manu-
facturing sectors: Garments, Textiles, ?harmnaceuticals, Electronic consumer goods and Electrical
white goods. The data, which cover the period 1997-1999, have recently been collected by the
"'Resitltb for the sector producing Diversified products turn out to be statistically insignificant.
51



World Bank. In order to test their hypotheses, the authors partition firms into the following three
groups Firms exporting at least 30% of their output are defined as Exporters (they represent 37%
of the total), non-exporting firms declaring to face foreign competition in their domestic market
are defined as Import-Competmng firms (27% of the total), and the rest of the firms belong to the
group of Protected firms (36% of the total). Note that firms belonging to the former two groups
are directly exposed to international competition and hence, by comparing their evolution to that
of protected firms, we can infer something about the pros and cons of globalization Consider un-
certainty first Let w,t- =, + V,t represent a variable pertaining to firm t at time t (i.e, the wage
rate, profits, sales, employment or prices), where A, and v,t are is its permanent and transitory
components. The variance of w,t can then be written as the sum of a' + a2, where the former
represents cross-sectional variation and the latter temporal variation of w,t. Hence, a2, captures
uncertainty due to, e.g, wage volatility Performing this decomposition shows that exporters and
import-competing firms are characterized by a higher transitory variance of wages, employment,
sales, prices and (to a lesser extent) profits. The authors also perform a regression analysis in
which the transitory component of firm-level variables is regressed on dummies for exporters and
import-competing firms, sectoral and regional dummies, and size. Estimation results show that in
most specifications the dummies for exporters and import-competing firms are positive, and they
are often also highly significant These results suggest that, consistent with the authors' prior,
exposure to international trade is associated with greater uncertaanty due to higher volatility of
wages, profits and employment.
Consider now the potential pros of trade exposure The authors focus, in particular, on traaning
and promotions. Their prior is that firms exposed to foreign competition have a greater incentive
to train their workforce in order to increase its productivity, thereby reducing the uncertainty
due to more volatile profits At the same time, workers have an incentive to produce a greater
effort to obtain promotions, thereby reducing the uncertainty due to higher wage and employment
volatility In this respect, data reveal that the share of workers engaged in training programs is
52



31% for exporters, 36% for import-competing firms and only 19% for protected firms. Further, the
percentage of workers being promoted in the firm's ladder in 1999 equals 4% for exporting firms,
1.4% for import competing firms and 1.7% for protected firms.
The regression analysis performed by the authors shows that the percentage of trained workers
is positively and significantly correlated with the dummy for import-competing firms, even after
controlling for size and for sectoral and regional dummies. Further, they regress thc probabihty of
a promotion on the dummies for exporters and import-competing firms. Estimation results reveal
that the former dummy is positive and significant, even after controlling for sectorel dummies, for
size and for a proxy of productivity growth.40
Hence, the evidence on Indian manufacturing firms suggests that, although trade liberalization
may have increased uncertainty for firms and workers, it may also have induced more investment
in training of the workforce on the part of firms, and more effort (aimed at promotions) on the
part of workers.
7.7   Trade amnd performance in          Hnd   n  manufacturinag: sorye tenative
conclusions
The lack of micro-level evidence of trade-induced productivity gains after trade liberalization in
India is at odds with the experience of other trade liberalizing developing countries One explana-
tion for these somewhat disappointing results is that, as noted by Srinivasan (2001, p. 9), "despite
radical changes in the trade policy reforms compared to the pre-1991 situation, India has remained
one of most autarkic developing countries". Indeed, as far as quantitative restrictions (QRs) are
concerned, although in 1991 the list of imports subject to QRs was drastically shortened, it still
remained quite long As estimated by Pursell (1996), although the share of manufacturing GDP
protected by quantitative restrictions and other non-tariff barriers was reduced from 90% in the
4"The authors also check the robuistness of their results with respect to the methodology of estimation In partic-
itai, they estimate the iupact of trade exposure on incertainty, training andl promotions uising a non-parametric
appinao h which protiuces remarkably consibtent resultb
53



pre-reform period to 36% in 1996, it remained high in absolute magnitude, mainly because of the
very high share of QR-protected consumer goods. As far as tariff barriers are concerned, Pursell
(1996) compares unweighted average tariff rates across 26 countries for 13 product categories
Strikingly, he finds that India's tariff rates rank highest or second highest for all product categories
and that India's average tariff rate of 51.6% is nearly three times as high as the average level for
26 developing countries Hence, more effort is needed on the part of India's government to reach
a degree of trade liberalization comparable to that of more successful developing countries
Another explanation for the lack of positive results may be related to India's endowment and
the structure of world trade In particular, when compared to other Asian countries that have
successfully exploited the opportunities disclosed by a greater participation in the world economy,
India is extremely poor in terms of human capital. For instance, as reported by Bajpal and Sachs
(1997), in 1992, the adult literacy rate in India was 50%, while the corresponding figures for
Indonesia, Thailand and Korea were 84%, 94% and 97%, respectively. This suggests that, at in
least in the medium-run, export-led growth in India has to rely on specialization in extremely low-
skill intensive productions This may not be that easy, however, since the problem of market access
is particularly relevant in these sectors As is well known, tariff peaks and tariff escalation in low-
skill intensive sectors severely limit access to industrial countries' markets by skill-poor developing
countries. As a symptom of how serious this problem may be for India note that, as shown by
Srimvasan and Tendulkar (2001), in the post-liberalization period, within manufacturing, the share
of exports of traditional labor-intensive goods either declined steeply (e g., leather manufactures)
or remained unchanged (e.g., ready-made garments) In contrast, the share of exports of chemical
products and engineering goods increased substantially. These trends suggest, among other things,
that because of the issue of market access in low-skill intensive industries, it may paradoxically
be easier for a skill-poor developing country to expand into comparative disadvantage rather than
comparative advantage industries after trade liberalization In this respect, an immediate policy
implication is that, as also suggested by Srinivasan (2001), India has no alternative to actively
54



participate in a new round of multilateral trade negotiations in order to enhance access for its
low-skill intensive exports.
Finally, several 'behind-the-border' constraints may have prevented India from reaping more of
the benefits of liberalization. In particular, notwithstanding the government's effort at deregulating
the economy, a still excessive regulation may have resulted in lower mobility of resources and hence
in little exploitation of trade-induced efficiency gains As an example (reported by Srinivasan,
2001), until 2000 the garment industry was reserved to the small-scale non-factory sector This
constraint prevented the organized factory segment of manufacturing, which is characterized by
much higher productivity per worker, to expand into a sector of strong comparative advantage for
the Indian economy
8    Concuions
In this paper we have reviewed the mucro-level evidence on the effects of trade hberalization in
developing countries We have focused, in particular, on the empirical relevance of the effects
predicted by the trade theory in the presence of increasing returns to scale, imperfect competition
and firm heterogeneity. The main findings can be summarized as follows
1) There is indirect evidence of trade-induced oroductivity gains in the developing countries
opting for freer trade. In particular, firms' productivity growth generally rises after trade reforms.
More interestingly, the evidence shows that the productivity of firms exposed to international
competition (i.e., exporters and import-competing firms) grows much more than that of firms
belonging to the non-traded sectors.
2) The evidence suggests that output share reallocations among firms with different productivity
levels are the main source of trade-induced productivity gains. This result is in line with trade
models, such as Melitz (2002), in which firm heterogeneity and sunk entry costs into foreign markets
play a crucial role in the mechanics of efficiency gains from trade liberalization.
3) Firms in import-competing sectors enjoy the highest efficiency gains from trade. One ex-
55



planation for this result is that the disciplining effect of trade liberalization is stronger in import
competing sectors Another is that the benefits stemming from cheaper imports of (embodied or
disembodied) technology are more relevant for firms belonging to the comparative disadvantage
technology-intensive sectors
4) There is no evidence of relevant scale efficiency gains This result, which runs counter to
conventional wisdom about the sources of gains from trade in the presence of scale economies,
can be explained as follows  First, the evidence suggests that large firms, which account for a
disproportionate share of industry output, are close to minimum efficient scale and hence their
scale efficiency is unaffected by trade liberalization Second, most small firms operating at an
inefficient scale are de facto insulated from foreign competition, since they only compete for local
market niches Third, the recent episodes of trade reform in the developing world often represent
examples of unilateral trade liberalization, which does not imply scale efficiency gains. Indeed, the
trade theory suggests that under certain conditions (e g , competition d la Cournot with segmented
markets) unilateral trade liberalization reduces scale efficiency in the trade liberalizing country.
5) There is robust evidence of a pro-competitive effect of trade liberalization  The pro-
competitive effect shows up as reduced price-marginal cost mark-ups for firms exposed to foreign
competition, especially if they belong to highly concentrated industries
6) There is no evidence, in the short-run, either of learning-by-exporting effects or of beneficial
spillover effects from foreign owned firms to local firms active in the same sectors In particular,
exporting firms are more efficient than non-exporting firms, but their productivity trajectories do
not seem to change after they break into foreign markets Similarly, foreign owned firms are in
general more efficient than local firms, but their presence does not seem to positively influence the
productivity of local firms belonging to the same sectors
7) There is evidence, however, of positive vertical FDI spillovers Hence, relevant productivity
gains may accrue to developing countries' firms due to the linkages between foreign firms and their
local suppliers.
56



8) Plant-level evidence suggests to reconsider the role played international tradc in the dramatic
increase in wage inequality observed in most trade liberalizing developing countries. In particular,
there is weak evidence that skill upgrading is correlated with measures of impoited technology.
Hence, trade liberalization, by reducing the price of imported technology, may spur the demand
for imported technology, which in turn may increase the relative demand for sldlled labor, as
technology adoption is a skill-intensive activity Further, there is evidence that exporting plants
expand at the expense of non-exporting plants after trade liberalization. Since the former are skill-
intensive relative to the latter, this implies that trade-induced output share reallocations among
firms with different skill-intensity can be a crucial determinant of industry sklll upgrading and
rising wage inequality.
9) There is evidence of a substantial increase in the demand elasticity for unskilled labor and
of a stable or decreasing demand elasticity for skilled labor, although it is not clear whether the
upward trend in the former is trade-induced From a theoretical standpoint, the labor demand
elasticity is relevant because its rise generally brings about a rise also in wage volatility. As for
the latter, however, there is direct evidence that firms exposed to international competition face a
higher wage volatility than firms belonging to the non-traded sectors.
10) There is no evidence of substantial employment contraction in import competing sectors
after trade reforms This implies that a dramatic short-run surge in unemployment is not a likely
consequence of trade liberalization. One possible explanation for this result is that, at least in
the short-run, the tendency toward contraction of the comparative disadvantage sectors is offset
by other forces. For instance, in the presence of imperfect competition, trade liberalization, by
reducing mark-ups, may force firms to expand output and employment to cover fLxed costs.
In short, trade liberalization brings about efficiency gains, mainly through a reallocation of
resources toward more efficient, outvard oriented and skill-intensive firms. In turn, this involves
skill upgrading, higher wage inequality and higher wage volatility. All this suggests that a greater
availability of skilled workers may magnify the efficiency gains from trade reform, on the one hand,
57



and dampen its negative distributional effects on the other. These results naturally lead to the
policy implication that a successful trade liberalization should be accompanied by policies aimed
at improving the average level of education of the workforce. This would in fact facilitate the
expansion of more efficient skill-intensive firms and the absorption of imported technology, while
at the same time reducing the pressure on the skill premium.
As far as India is concerned, a further policy implication suggested by the somewhat disap-
pointing evidence on the effects of trade reform on Indian firms' productivity growth is to further
deregulate the economy in order to stimulate the firm to firm mobility of resources so as to allow
a better exploitation of trade-induced efficiency gains
It is worth noting, in closing, that the above results are not robust enough, however They
are often plagued by methodological hurdles (in particular, by the difficulty to identify the trade
effects), or by the poor quality of the data, and in particular by the fact that, while most trade
effects only materialize in the long-run, most empirical analyses are bounded, instead, to look at
data which only cover very short time spans. Empirical studies on the effects of India's trade liber-
alization are not exempt from these problems. This may help explain, for instance, the contrasting
results concermng the productivity gains from India's trade reform. Hence more effort is necessary
to better our understanding of the effects of trade reforms in developing countries in general, and
in India in particular.
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