We can use 2 parameters to understand the effects of trade policy. The first parameter is the extensive margins. Using this parameter, trade policy can protect the inefficient incumbent firms by charging a higher market entrance cost. The second parameter is the intensive margins. In this parameter, the trade liberalisation can cause the efficient firms to expand their output and raise more profits. In conclusion, we can see that trade policy has different effects on producers within the same industry. Whether inefficient firms are characterised as high cost or low quality is important, because quality plays a crucial role in understanding firm behaviour.
Trade costs also makes an important role as the determinants of trade policy impact. We can see it from the reduction in specific costs affects firm behaviour in a different way than an ad val cost reduction. If low price reflects low quality, then, an increase in specific costs disproportionately raises the costs of low-quality firms. Therefore, a decrease in trade costs will activate the entry by low-quality firms. It is necessary to incorporate heterogeneity, quality, and specific costs to show supply and pricing patterns and also to understand the impact of trade policy. Thus, it is important to acknowledge whether high prices reflect high quality and to determine the contribution of specific costs to total trade costs.
There are some researches prove that FOB prices and distance to market have a positive relationship. This evidence motivates the introduction of quality because such a relationship is not consistent with the standard productivity heterogeneity model. By bringing quality into the firm heterogeneity model together, they propose a new case which high FOB-price firms produce high-quality goods, so these firms can sell to more distant markets.
Specific trade costs also generate a positive relationship between distance and quality. The relative prices of high-quality results in high-price, so therefore, goods that are lower in distant markets have a strong relative demand for high-quality goods in these markets. But, it is hard to tell which of these two mechanisms is the main incentive.
The knowledge of origin prices and market prices can be used to determine product delivery patterns. We can estimate the trade costs by using only observed price data (not including the information on undelivered items, which causes a bias). Next, by assuming a particular market structure, we can use the origin price data to measure production costs and goods quality as these data are unaffected by interregional trade costs. In conclusion, we can find how significant is the specific-cost component in trade costs.
The quality elasticity is a key matter of whether high-cost firms can make large profit by producing high-quality goods, because a higher elasticity implies greater profitability for high-cost firms. The presence of specific costs affects profitability in distant markets because relative demand for high-quality goods is greater when there are specific trade costs. Therefore, the relationship between quality and production costs will be overestimated if we ignore the specific costs.
Only specific costs depend on the distance between markets, therefore the elasticity of specific costs with respect to distance is larger than that with respect to ad val costs. These empirical results have implications for public policy. The specific costs are more sensitive to geographic distance, and policy initiatives, like improving infrastructure, may reduce specific costs by easing the burden of distance. Welfare gains may be larger than previously thought, based on only ad val costs because specific trade costs cause more distortions than ad val costs.
Source: World Economic Forum
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