Improved access to foreign inputs has increased firms’ productivity in a number of countries. Analysing data for Hungary, this research explores the channels through which imported inputs boost productivity and finds that the positive effects are particularly strong for foreign-owned firms. The study’s counterfactual analysis also identifies powerful trade policy complementarities: reduction of import tariffs has its largest effect on productivity when accompanied by liberalization of licensing and foreign direct investment.
Imported inputs play a significant role in boosting firms’ productivity in Hungary
Understanding the links between trade and aggregate productivity is one of the major challenges in international economics. To learn more about these links at the microeconomic level, a recent body of research has been exploring the effects of imported inputs on firms’ productivity. Imported inputs constitute the majority of world trade and studies show that improved access to foreign inputs has had a positive impact on firms’ productivity in several countries, including Chile, India and Indonesia.
An important next step in this research agenda is to investigate the underlying mechanisms through which imports increase productivity. As Hallak and Levinsohn (2008) emphasize, to evaluate the welfare and redistributive implications of trade policies, we need to understand which firms gain most, through what channels and how the effects depend on the economic environment.
Three facts about imported inputs
To explore these questions, we analyse a dataset containing detailed information on imported goods for essentially all Hungarian manufacturing firms during the period 1992-2003. We document three basic facts about these firms’ importing behaviour:
- First, there is substantial heterogeneity in their import patterns. Half of the firms do not import at all. Larger firms or those that have been foreign-owned are more likely to import.
- Second, firms’ spending on imports is concentrated on a few core products. They spend little on their remaining imports.
- Third, the ‘extensive margin’ – importing by new firms and/or of new imported products – plays a large role in explaining both the aggregate trend and firm-level fluctuations in the growth of imports.
Motivated by these stylized facts, we develop a model of firms that use differentiated inputs to produce a final good. In each period of our model, firms must pay a fixed cost for each variety they choose to import. Imported inputs affect firms’ productivity through two distinct channels: they may have a higher price-adjusted quality; and they may be imperfect substitutes for domestic inputs. Because of these forces, firms’ productivity increases when there is an increase in the number of varieties imported. Our model also permits rich heterogeneity across products and firms.
In taking this model to the data, we face the key empirical challenge that imports are chosen endogenously by firms. We deal with this identification problem using a structural approach that exploits the product-level nature of the data. Our model implies a firm-level production function in which output depends on capital, labour, materials and a term related to the number of imported varieties.
The productivity effects of importing
Our results show that the productivity gains from imported inputs are substantial. In our baseline case, increasing the fraction of tradable goods imported by a firm from zero to 100% would increase revenue productivity by 22% and quantity productivity by 24%. We continue to estimate large productivity gains with alternative specifications. These results suggest that imported inputs play a significant role in shaping firm performance in the Hungarian economy.
We then decompose the import effect into the two channels of quality and imperfect substitution. We first note that for a given productivity gain from importing a good, the degree of substitution governs a firm’s expenditure share of foreign versus domestic purchases. For example, when foreign and domestic inputs are close to perfect substitutes, even if the productivity gain from imports is small, the import share should be high.
Based on this idea, we infer the relative magnitude of the two channels by comparing the expenditure share of imports for firms based on differences in the number of imported varieties. We find that combining imperfectly substitutable foreign and domestic varieties is responsible for roughly a half of the productivity gain from imports.
This finding parallels the evidence that combining foreign and domestic varieties increased firms’ product scope in India (Goldberg et al, 2010). It is also consistent with theoretical arguments that complementarities, which amplify differences in input quality, may help explain large cross-country income differences.
Foreign-owned firms are more efficient in using imported inputs and have lower fixed costs of importing
We next explore whether the benefits from importing differ between domestic and foreign-owned firms. Because foreign firms have know-how about foreign markets and can access cheap suppliers abroad, they may gain more from spending on imports. This is an important possibility because firms that had been foreign-owned played a central role in Hungary: during the period 1992-2003, their share of manufacturing sales increased from 21% to 80%.
When we re-estimate our model allowing for differences in the efficiency of import use by ownership status, we find that firms that have been foreign-owned benefit by about 24% more than purely domestic firms from each $1 they spend on imports. We also conduct an event study of ownership changes, which yields suggestive evidence that part of the premium in the efficiency of import use is caused by foreign ownership. This result implies a potential complementarity between importing and the presence of foreign firms.
Our analysis also yields estimates of the product-level fixed costs of importing. We find that these costs increase as the number of imported products increases. In addition, the fixed cost schedule of firms that have been foreign-owned is below that of domestic firms. Lower import costs are thus a second factor generating higher benefits from importing for foreign-owned firms.
Economic and policy implications of the model
We develop two applications of the model to study the economic and policy implications of our estimates. We first quantify the contribution of imports to productivity growth in Hungary during the period 1992-2002. Our estimates imply a productivity gain of 21.1% in the Hungarian manufacturing sector, of which 5.9 percentage points (more than a quarter) can be attributed to import-related mechanisms.
Approximately 80% of these import-related gains are due to the increased volume and number of imported inputs; while the other 20% are the result of increased foreign ownership in combination with foreign-owned firms being better at using imports.
Hungary’s economy benefits from the complementarity between importing and the presence of foreign firms
Thus, imports contributed substantially to economic growth in Hungary and the complementarity between importing and the presence of foreign-owned firms had a sizable aggregate effect. These results complement the findings of Gopinath and Neiman (2014), who emphasize the role of imported inputs in driving fluctuations in aggregate productivity in Argentina.
In our second application, we use simulations to explore the productivity implications of tariff policies. Intuitively, by reducing the cost of imported inputs, a tariff cut should raise both firm-level and aggregate productivity. Our main result is that the size of the aggregate productivity gain depends positively on two broad features of the environment: first, the initial participation of producers in importing; and second, the presence of foreign-owned firms.
Perhaps surprisingly, higher initial participation in importing – due either to low tariffs or low fixed costs – implies larger gains from a tariff cut. This is because the set of inputs whose prices are affected is larger and hence firms save more with the tariff cut. In turn, the presence of foreign-owned firms matters because they are better at using imports.
These patterns lead to complementarities between different liberalization policies. For example, our simulations show that tariff cuts increase productivity more when the fixed costs of importing – such as licensing and other non-tariff barriers – are also reduced. Because foreign-owned firms are more effective at using imports, there is a similar complementarity between tariff cuts and liberalization of foreign direct investment (FDI).
These complementarities seem broadly consistent with India’s liberalization experience in the early 1990s. Consistent with the fixed cost complementarity, tariff cuts in India, which were accompanied by the dismantling of substantial non-tariff barriers, led to rapid growth in new imported varieties (Goldberg et al, 2010) and a large increase in firms’ productivity (Topalova and Khandelwal, 2011). Consistent with the foreign ownership complementarity, these effects were stronger in industries with higher FDI liberalization (Topalova and Khandelwal, 2011).
Tariff cuts increase productivity more when the fixed costs of importing – such as licensing and other non-tariff barriers – are also reduced
Our tariff experiment also highlights the differential implications for domestic input demand of the quality and imperfect substitution channels. When the benefit from imports comes from quality differences, domestic import use (in an intermediate range) is quite sensitive to tariffs. In contrast, when the benefit from imports comes from imperfect substitution, domestic input use is a relatively flat function of tariffs.
This difference is intuitive: when foreign goods are close to perfect substitutes, even a small price change can bring about large import substitution. Another force is that losses to domestic input suppliers caused by a tariff cut are partially offset by higher demand for their products due to increased productivity.
Because our estimates assign a significant role to imperfect substitution and because of the second force, we obtain a relatively inelastic demand curve for domestic inputs. One lesson from this analysis is that the magnitude of redistributive losses due to import substitution depends strongly on both the extent of substitution and the initial level of tariffs. More broadly, identifying the specific mechanisms driving the effects of trade policies can help evaluate the impact of these policies in other dimensions.
Future directions
Our framework and analysis may be extended in a number of ways:
- One possibility is to seek reduced-form evidence for our new predictions, such as those concerning policy complementarities.
- A second direction is to use our model to examine concrete episodes – such as crises, as explored by Gopinath and Neiman (2014) – in which the imported goods margin is relevant.
- A third direction is to extend our framework to incorporate capital goods. Caselli and Wilson (2004) suggest that because of the technology embedded in capital imports, they can have a substantial effect on productivity.
Investigating these directions can improve our understanding of the links between international trade and economic growth.
