Pass-through of Trade Costs to U.S. Import Prices
One sentence summary: Robust to the consideration of constant
versus variable markups, the effects of measured trade costs on U.S. import prices
are through source-specific marginal costs of production, with the contribution
of quality dominating those of productivity and markups.
The corresponding paper by Hakan Yilmazkuday has been published
at Review of World Economics.
Abstract
This paper measures the pass-through of trade costs into
U.S. import prices by using actual data on duties/tariffs and freight-related
costs. The key innovation is to decompose the indirect effects of trade costs
(on prices) into the effects on markups, quality and productivity while
measuring/interpreting the pass-through of trade costs into welfare. Robust to
the consideration of variable versus constant markups, there is evidence for
incomplete pass-through, mostly due to the negative indirect effects of trade
costs on marginal costs, suggesting that lower trade costs are associated with
imports that have higher marginal costs; markups are affected relatively less.
When the effects of trade costs on marginal costs are further decomposed into
their components, the positive contribution of quality dominates in all cases,
followed by the negative effects of productivity, suggesting that lower trade
costs are associated with higher-quality imports that have been produced with
lower productivity.
Non-technical Summary
Trade costs are partly determined by trade policy, and,
thus, their reflection in the welfare of economic agents through prices (i.e.,
the pass-through of trade costs) is of political interest. Accordingly, the
empirical literature on international trade has focused on the effects of
changes in trade costs on export prices (of firms or source countries),
referring to the gains from trade through export-oriented growth, especially by
relying on dramatic liberalizations of trade for identification purposes. Nevertheless,
evidence on pass-through of trade costs to import prices is limited, which is
important for import competition as well as household welfare in the
destination country.
Although calculating the pass-through of trade costs into
import prices is straightforward when the corresponding data are available,
calculating the underlying details is the key to form trade policy, because, other
than the direct effects of trade costs on import prices, one has to consider
their indirect effects through other components of prices, namely markups and
marginal costs, where the latter also includes information on quality and
productivity (in the source country). As a simple example, if more liberal
trade leads to an increase in import prices due to an increase in quality, this
may be welfare improving in the importer country (depending on the trade-off
between increased prices and quality), while an increase in import prices due
to a reduction in productivity (with no quality effects) would be welfare
worsening. Therefore, in a typical welfare analysis of an importer country, the
pass-through of trade costs to prices should be controlled for markup effects
as well as quality and productivity effects.
This paper achieves such an investigation by decomposing the
U.S. import prices (measured at the U.S. dock) into marginal costs, markups and
trade costs at the HTS 10-digit good level. Marginal costs are further
decomposed into quality, productivity, and other factors. Using a demand-side
model, for robustness, we consider both variable and constant markups in our
investigation. After controlling for several fixed effects, we estimate the
pass-through of trade costs to prices, markups, marginal costs, quality, and
productivity. We also distinguish between the effects of duties and
freight-related costs. Moreover, we use actual data on duties and
freight-related costs to construct multiplicative trade costs; hence, our
results are robust to alternative specifications of trade costs (such as
additive trade costs).
When data for prices and trade costs are available (as in this paper), the main issue is the measurement of variables such as markups and marginal costs of production where the latter can further be decomposed into quality, productivity, and other factors (e.g., other local production costs). This paper introduces a new methodology for the identification of all of these variables. In particular, first, the price elasticity of demand is estimated using data on quantities and prices, where an estimation methodology that is robust to simultaneity bias is used. Second, the estimated price elasticities are used to calculate markups, where we consider the cases of both variable markups (due to constant absolute risk aversion utility function of importers) and constant markups (due to constant relative risk aversion utility function of importers). Third, marginal costs of production are identified by using the data on prices and trade costs together with estimated markups. Fourth, quality measures are identified as the importer preference parameters (i.e., demand shifters) that are calculated by controlling the quantities traded for the effects of prices and other control variables (i.e., good-and-time fixed effects). Fifth, since measures of quality and marginal costs of production are shown to be positively related in the literature, the relationship between the estimated measures of quality and marginal costs of production is tested by running a regression where all other factors are controlled for; the part of the marginal costs of production that cannot be explained either by quality or other factors is defined as the inverse of productivity. Once these variables are identified, we continue with investigating their interaction with trade costs.
When data for prices and trade costs are available (as in this paper), the main issue is the measurement of variables such as markups and marginal costs of production where the latter can further be decomposed into quality, productivity, and other factors (e.g., other local production costs). This paper introduces a new methodology for the identification of all of these variables. In particular, first, the price elasticity of demand is estimated using data on quantities and prices, where an estimation methodology that is robust to simultaneity bias is used. Second, the estimated price elasticities are used to calculate markups, where we consider the cases of both variable markups (due to constant absolute risk aversion utility function of importers) and constant markups (due to constant relative risk aversion utility function of importers). Third, marginal costs of production are identified by using the data on prices and trade costs together with estimated markups. Fourth, quality measures are identified as the importer preference parameters (i.e., demand shifters) that are calculated by controlling the quantities traded for the effects of prices and other control variables (i.e., good-and-time fixed effects). Fifth, since measures of quality and marginal costs of production are shown to be positively related in the literature, the relationship between the estimated measures of quality and marginal costs of production is tested by running a regression where all other factors are controlled for; the part of the marginal costs of production that cannot be explained either by quality or other factors is defined as the inverse of productivity. Once these variables are identified, we continue with investigating their interaction with trade costs.
The results of pass-through analyses show that the
elasticity of U.S. import prices with respect to overall trade costs (i.e.,
duties/tariffs plus freight-related costs) is about -0.90. During an episode
of reducing trade costs by 1%, under the assumptions of variable (constant) markups,
this corresponds to a 0.90% increase in prices that
is decomposed into 1.74% (1.90%) of an increase in marginal costs of
production, 0.16% (0.00%) of an increase in markups and 1.00% (1.00%) of a
reduction in trade costs (i.e., defined as direct effects of trade costs). The
increase in the marginal costs of production 1.74% (1.90%) is further
decomposed into 1.10% (1.20%) of an increase in quality, and 0.63% (0.70%) of a
decrease in productivity for the cases of variable (constant) markups.
Therefore, the contribution of quality has the lion's share in explaining the
effects of trade costs on prices, followed by productivity effects and markups.
Considering import competition and/or household utility, if
we accept the inverse of import prices controlled for quality as a rough
measure of welfare, 1% of a reduction in trade costs would result in 0.20%
(0.30%) of an increase in welfare under the assumption of variable (constant)
markups. When we decompose trade costs into duties/tariffs and freight-related
costs, such values change as -0.21 (0.75) for duties/tariffs and 0.25 (0.22)
for freight-related costs, under the assumption of variable (constant) markups.
These results show the importance of considering alternative measures of trade
costs in pass-through calculations where freight-related costs play an
important role, which is mostly ignored in the corresponding literature
focusing on duties/tariffs.