Export Variety and Country Productivity: ESTIMATING THE MONOPOLISTIC COMPETITION MODEL WITH ENDOGENOUS PRODUCTIVITY by Robert Feenstra Department of Economics University of California, Davis and NBER Hiau Looi Kee The World Bank March 2006 Abstract This paper provides evidence on the monopolistic competition model with heterogeneous firms and endogenous technology. We show that this model has a well-defined GDP function where relative export variety enters positively. The GDP function is estimated on data for 44 countries from 1980 to 2000. Export variety to the United States increases by about 10% per year, or eight times over these two decades. Instruments such as tariffs and distance are shown to affect export variety, but the fall in U.S. tariffs explains only a small part of export variety growth. The eight-fold increase in export variety is associated with a 10% productivity improvement for exporters. Overall, the model can explain 40% of the within-country variation in productivity, but only a small fraction of the between-country variation in productivity. JEL code: F12, F14 Keywords: productivity, export variety, translog * The authors thank Russell Davidson, Jonathan Eaton, Marcelo Olarreaga, David Weinstein and the anonymous referees for helpful comments. Research funding from the World Bank is cordially acknowledge. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors, and do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Address for contact: Robert Feenstra, Department of Economics, University of California, Davis, CA 95616; Phone (530)752-7022; Fax,(530)752-9382; E-mail, [email protected]. Introduction Empirical research in international trade (as well as other fields) has made it clear that productivity levels differ a great deal across countries.1 This conclusion begs the question of where the technology differences come from. While various explanations have been proposed that do not depend on international trade,2 our interest here is whether trade itself can explain the productivity differences across countries. This conclusion is suggested by recent models of monopolistic competition and trade in which productivity levels are endogenous. Two examples of this recent literature are Eaton and Kortum (2002) and Melitz (2003). Eaton and Kortum allow for stochastic differences in technologies across countries, with the lowest cost country becoming the exporter of a product variety to each location. In that case, the technologies utilized in a country will depend on its distance and trade barriers with other countries. Melitz allows for stochastic draws of technology for each firm, and only those firms with productivities above a certain cutoff level will operate. A subset of these firms – the most productive – also become exporters. Melitz shows how the average productivity in a country is affected by changes in trade barriers and transport costs. A reduction in trade barriers, for example, draws less efficient firms into exporting, but they are still more efficient than the marginal domestic firm. It follows that average country productivity rises. Empirical testing of this class of models can proceed by utilizing firm-level data and inferring the productivity levels of firms. That approach is taken by Bernard et al (2003) for U.S. firms; Eaton, Kortum and Kramarz (2003, 2004) for French firms; and Helpman, Melitz and Yeaple (2004) for U.S. multinationals operating abroad. When firm level data are available, it is 1 See, for example, from the work of Bowen, Leamer and Sveikauskas (1987), Trefler (1993, 1995), and Davis and Weinstein (2001) on the Heckscher-Ohlin model 2 Explanations for the aggregate productivity differences across countries include geography/climate (Sachs, 2001), or colonial institutions (Acemoglu, et al, 2001), or social capital (Jones and Hall, 1999).2 highly desirable to make use of it like these authors do. But for many countries such data are not available, and in those cases, we are still interested in determining the extent to which openness to trade can explain country productivity. That is our objective in this paper, using a broad cross-section of advanced and developing nations and disaggregating across sectors. In section 2 we review the monopolistic competition model with heterogeneous firms, from Melitz (2003), Bernard, Redding and Schott (2004) and Chaney (2005). We emphasize some features of that model that these authors do not: for example, the “cutoff” productivity of firms producing for either the domestic or export markets are both at the socially optimal level. This means that we can use a GDP function for the economy, similar to the competitive case. In each sector, only a subset of firms become exporters, and these are the most productive firms. It follows that when the share of exporting firms rises, or equivalently, the share of exported varieties rises, then average productivity and GDP increase. Therefore, relative export variety enter the GDP function positively.3 Our empirical specification is developed in section 3. We draw on Harrigan (1997), who estimates a translog GDP function in a competitive model allowing for industry productivity differences across countries. In our case, we allow for exogenous country-wide differences in productivity, which are country fixed effects in the translog function. At the industry level, we assume that the distribution function for firm productivities is the same across countries, so productivity is determined by the endogenous “cutoff” levels for firms.4 A goal of the empirical work is to determine what amount of the productivity differences across countries and over time 3 With a Pareto distribution for firm productivities, we also show that relative export variety enters with an exponent related to the elasticity of substitution and the Pareto productivity parameter. This result is similar to the formulation of the gravity equation in Chaney (2005). 4 Assuming that the distribution of firms productivities is the same across countries is consistent with Melitz (2003), Bernard, Redding and Schott (2004) and Chaney (2005), but this assumption is not made by Eaton and Kortum (2002).3 are determined by endogenous versus exogenous factors. In section 4 we estimate the GDP