An empirical model of sunk costs and the decision to export

POLIcy RESEARCH WORKING PAPER *@ A An Empirical Model of Sunk Costs and the Decision to Export Mark J. Roberts James RP Tybout The World Bank Intermational Economics Department L ; r~ International Trade Division March 199S  |POLICY RESEARCH WORKING PAPER 1436 Summary findings Exports respond unpredictably to a change in real The results, which control for both observed and exchange rates, suggests evidence from the 1980s. unobserved sources of plant heterogeneity, indicate that Recent theoretical work (Paul Krugman and Richard prior export market experience has a substantial effect Baldwin) explains this as a consequence of the sunk costs on the probability of exporting, but its effect depreciates associated with breaking into foreign markets. Sunk costs fairly quickly. The reentry costs of plants that have been include the cost of packaging, upgrading product quality, out of the export market for a year are substantially establishing marketing channels, and accumulating lower than the costs of a first-time exporter. After a year information on demand sources. out of the export market, however, the reentry costs are Roberts and Tybout use micro panel data to estimate a not significantly different from the entry costs. dynamic discrete-choice model of participation in export Plant characteristics are also associated with export markets, a model derived from the Krugman-Baldwin behavior: Large old plants owned by corporations are sunk-cost hyster --is framework. more likely to export than other plants. Applying the model to data on manufacturing plants in Variations in plant-level cost and demand conditions Colombia (1981489), they test for the presence of sunk have much less effect on the profitability of exporting entry costs and quantify the importance of those costs in than variations in macroeconomic conditions and sunk explaining export patterns. The econometric results costs do. It appears especially difficult to break into reject the hypothesis that sunic costs are zero. fereign markets during periods of world recession. This paper - a product of the International Trade Division, International Economics Department - is part of a larger effort in the department to describe the micro foundations of export supply response. The study was fundedby the Bank's Research Support Budget under the research project "Micro-Foundations of Successful Export Promotion" (RPO 679-20). Copies of this paper are available free from the World Bank, 1818 H StreetNW, Washington, DC 20433. Please contactJermifer Ngaine, room R2-052, extension 37959 (37 pages). March 199S. Thc Poly Rcscb lrorkg Paper S by dates tPelicy Rs of wr c pDogriem to Cent e 5 e of se about dae)opt bsum An *beaitnof th sern is =to et the fid& ow quk*, ecx if the presatiom are Amssm fbefypolisbed. 7he papers am7ythe xammof deaSch 2osnd sboud6 be dand ckedoccodigly. 7lOc0sq _drrtt= cand cndsi re the autbors'oum anbuld onot be akds o the World Baxk, its Fxeav Board of Dirasors or any of its cmbr outrk&s Produccd by the Policy Rescarch Dissemination Ccnter  An Empirical Model of Sunk Costs and the Decision to Export Mark J. Roberts Pennsylvania State University and James R. Tybout Georgetown University We would like to thank David Card, Terri Devine, Avinash Dixit, Chris Flinn, Zvi Griliches, James Hanna, James Heckman, Ariel Pakes, David Ribar, Dan Westbrook and an anonymous refree for helpfil discussions or comments. Support for this paper was provided by the Research Administion Depatmn of The World Bank (RPO 679-20).  SUMMar The responsiveness of exports to changes in the incentive structure has long interested policy makers. But the empirical literature has provided little guidance on when or how exporters will respond to new incentive structures. Research in this area has produced a variety of supply elasticity estinates that vary dramatically across countries and time periods, and few hints on how to reconcile the diverse results. Paul Krugman and Richard Baldwin have recently argued that the emirical literature fails because there are sunk costs associated with breaking into foreign markets - including upgrading product quality, packaging, and the establishment of marketing channels. Hence the currcnt-period export supply function depends upon the number and type of producers that were exporting in previous periods. Further, start- up costs mean that transitory policy changes or macro shocks can lead to permanent changes in market structure, and thus that trade flows may not be reversed when a stimlus is removed. That is, sunk entry or exit costs produce "hysteresis' in trade flows. Finally, wlhen future market conditions are uncertain, sum,. costs make pattrns of entry and exit dependent upon the stochastic processes that govern variables like dhe exchange rate. Taking the Baldwin/Krugman perspective as a point of departure, this paper develops an econometric model of a plant's decision to export. The model is fit u mwiro data for a large group of anufacturing plants in Colcmbia from 1981-1989, and used to direcdy examine the determinants of a plant's export decision for consistency with the theory. The econometric results reject the hypothesis that sunk costs are zero. They also reveal that the re-entry costs of plants that have been out of the export market for a year are substantially less than the costs of a first-time exporter. Beyond a one year absence, however, the re-entry costs are not significantly different than those faced by a new exporter. This is consistent with the view that an important source of sunk entry costs for Colombian exporters is the need to accmulate information on demand sources, information that is likely to depreciate upon exit from the market. While the results indicate that sunk costs are a significant source of export market persistence, both observed and unobserved plant characteristics also contibute to an individual plant's export behavior. For example, plants that are large, old, and owned by corporations are all more likely to export. A number of policy implications emerge. For example, it appears especially difficult to break into foreign markets during periods of world recession. Also, although only 25 percent of the plants in the Colombian panel exported during the sample period, the results imply that sufficiently favorable macro conditions and/or reductions m sunk costs could make exporting profitable for a much larger proportion of plants. Finaly, and most generaly, the estimates imply that countries undertaldng export promotion policies should distinguish measures aimed at exanding the export volume of exisitag exporters from policies aimed at promoting the entry of new exporters.  I. Introduction Why is it that in some countries and time periods, a given trade and exchange rate regime supports large scale production for foreign markets, while in other countries or time periods, the same policies appear to induce a minimal export response? Put differently, why are cstimates of export supply equations so sensitive to the time period or country under study? In a recent series of papers Richard Baldwin, Paul Krugman, and Avinash Dixit have proposed an answer.' Thay begin from the assumption that non-exporters must incur a sunk entry cost in order to enter foreign markets. This mnakes the current-period export supply function dependent upon the number and type of producers that were exporting in previous periods. Further, it means that transitory policy changes or macro shocks can lead to permanent changes in market structure, and thus that trade flows may not be reversed when a stimulus is removed. That is, sunk entry or exit costs produce 'hysteresis" in trade flows. Finally, when future market conditions are uncertain, sunk costs make patterns of entry and exit depeodent upon the stochastic processes that govern variables such as the exchange rate. Under plausible assumptions, greater uncertainty makes trade flows less responsive to changes in these variables. None of these implications of sunk costs is captured in standard empirical export supply functions, and all could contribute to the "instability" of empirical relationships.2 To date, attepts to empirically validate the sunk-cost hysteresis framework have focussed on 'See, in particular, Dixit, 1989a and 1989b; Baldwin, 1988 and 1989; Baldwin and Krugman, 1989; Krugman, 1989). 2In their review of empirical studies of price and income elasticities for traded goods, Goldstein and Khan (1985, pp. 1087-1092) report a very wide range of estimates for the supply elasticity of total exports from developed countries. They conclude that 'excluding the United States, the supply-price elsticity for the total exports of a representative industrial countly appears to be in the range of one to four. The supply elasticity for U.S. exports is probably considerably higher than that, perhaps even reaching ten to twelve.' They also discuss some evidence indicating that the response of export supply to price changes is slower than demand-side adjustments. They speculate dh this may refict start-up costs associated with export production or greater unceUity assocated with sHling abroad. I  asymmetries in the response of trade flows to exchange rate appreciation versus depreciation.3 A limitation of this approach is that data on the volume of trade flows, even for very disaggregated commodities, cannot distinguish the entry and exit of exporters from the supply response of continuing exporters. With the exception of Campa (1993), the foreign market entry and exit patterns, which are the focus of the theory, have not been exanined for consistency with the sunk- cost hysteresis model.' In this paper we develop an empirical test of the sunk-cost hysteresis model that directly examines entry and exit patterns in plant-level panel data. We develop and estimate a dynamic discrete choice model of the decision to export when sunk entry or exit costs are present. In essence, this model predicts exporting status in the current period as a function of plant characteristics, previous exporting status and a serially correlated disturbance. It not only permits us to formally test for the presencc of sunk costs (using coefficients on lagged exporting status), it allows us to summarize the effects of time, individual producer characteristics, and prior exporting experience on the probability of participating in the export market. The data we use describe the export patterns of I The empirical evidence derived from trade flow data has produced no clear consensus. Based on aggregate U.S. data, Baldwin (1988) concludes ftat the substantial appreciation of the U.S. dollar during the early 1980's resulted in a structural shift in U.S. impon pricing equations. This is consisteant with sunk-cost hysteresis. In contrast, Gagnon (1987) finds that trade has been more responsive to relative prices in the more uncertain post-Bretton Woods era, a result inconsistent with some versions of the hysteresis model. Using time-series data for U.S manufacturing industries. Feinberg (1992) fmds that exports became more dispersed across destination markets as the dollar depreciated, suggesting that there was firm entry into new country markets. The effect was weaker in industries where distribution networks, and thus presumably sunk entry costs, are more important. Parsley and Wei (1993) focus on bilateral U.S.-Canada and U.S.-Japan trade flows fbr very disaggregated commodities. They find that both the past history of U.S. exchange rate changes and measures of exchange- rate volatility had no significant effect on trade flows. Both findings ar inconsistent with the hysteresis model. ' Campa (1993) examines the number of foreign firms that made direct investnents in the 61 U.S. wholesale trade industries over the 1981-87 period. He finds that exchange-rate uncertainty, which is proxied by the stndard deviation of the monthly rate of growth of the exchange rate, is negatively cormlated with the number of firms investing in the U.S.. He also reports that an industry's sunk costs, which arc proxied by the advertising-sales ratio and ratio of fixed assets to net worth of firms in the industry, is negatively correlated with foreign-firm entry. Both findings are consistent with the hysteresis model. Although not in a trade context, related work by Bresnahan and Reiss (1991, 1994) shows how data on net entry into a market can be used to make inferences about the ratio of sunk entry and exit costs to avenge profitability. Their technique exploits the asymmetric response of the number of producers to population (demand) changes across diffierent geographic markets. However, as they acknowledge, persistance in behavior due to permanent cross-producer differences in profitability can create the appearance of sunk costs in their model. 2  Colombian manufacturing plants in four major exporting industries over the period 1981-1989, a nine- year span characterized by substantial changes in aggregate demand and real exchange rates. The empirical results strongly reject the hypothesis that sunk costs are zero. This implies that prior export market experience significantly affects the current decision to export. Further, although recent experience in foreign markets is extremely important, its effect depreciates fairly quickly over time. A plant that exported in the prior year is up to 40 percentage points more likely to export in the current year han an otherwise comparable plant that has never exported. But by the time a plant has been out of the export market for two years its probability of exporting differs little from that of a plant that has never exported. Several policy implications emerge. First, although only 25 percent of the plants in our panel exported during the sample period, our results imply that sufficiently favorable macro conditions ador reductions in sunk costs could make exporting profitable for a much larger proportion of plants. Second, our estimates imply that countries undertaldng export promotion policies should distinguish measures aimed at expanding the export volume of exisitng exporters from policies aimed at promoting the entry of new exporters. In the next section of the paper we summarize the theoretical sunk-cost model. The third section provides an overview of the patterns of export participation among Colombian man uri plants between 1981 and 1989. The fourth section develops an econometric model of the export decision, and the fifth section presents our results. We briefly summarize and draw conclusions in the sixth section. Readers uniterested in methodological issues may wish to skip section E and readers uninterested in econometric problems may wish to skim section 1". I. A Theoretical Model of Entry and Exit with Sunk Costs As reviewed in Krugman (1989), sunk costs affect the export supply function for several 3  reasons. First, and most obviously, once the sunk costs of entering a market have been met, a producer will remain in that market as long as operating costs are covered. This implies that changes in policy, exchange rates, or prices in foreign nmarkets can permanently alter market structure and thus observed export behavior. For example, devaluations that induce entry into the export market may permanently increase the flow of exports, even if the currency subsequently appreciates. Second, even if current conditions appear favorable to exporting, they may not induce entry into the export narket if they are regarded as transitory. In this case, the expected future stream of operating profits may not cover the sunk costs of entering foreign narkets. Thus large devaluations may induce little response from potential exporters if they are perceived as transitory. Finally, as formally demonstrated by Dixit (1989a), the combination of sunk costs and uncertainty about future market conditions can create an option value to waiting. Dixit's simulation resdts suggest that even small amouts of uncertity can significantly magnify the degree of persistence in a producer's expordng status. To motivate our empirical work, we begin by reviewing the theoretical models that generate these results (see footnote 1 for references). For each period t, le, the ti plant's expected gross profits when exporting differ from its expected gross profits when not exporting by the amount ir,(o,sJ. Here p, is a vector of market-level forcing variables that the plant takes as exogenous (e.g., the exchange rate), and s,, is a vector of state variables specific to the plant (e.g., capital stocks and geographic location). Once in the market, plants are assumed to freely adjust export levels in response to current market conditions (Baldwin, 1989). Thus the function T#,,Sd represents the increment to expected profits associated with exporting in year t, assuming that the profit-maximizing level of exports is always chosen. These profits are gross because they have not been adjusted for the sunk costs of foreign mariet entry or exit. Assume that if the i* plant last exported in year t-j (j 2 2) it faces a re-entry 4  cost of F , so upon resuning exports in year t it earns r1(plsd - Fl . Similarly, If the plant had never exported previously, it faces an entry cost of P57 and earns ir1(p,,sJ - P7 in its first year exporting. Finally, a plant that exported in period t-1 earns r,(p,,sd) during period t by continuing to export and -X, if it exits. As in Dixit (1989a), these sunk costs represent the direct monetary costs of entry and exit. The j superscript generalizes previous models to allow sunk re-entry costs to depend on the length of absence from the market. This could reflect the increasing irrelevance of the knowledge and experience gained in earlier years, or the increasing cost of updating old export products. The i subscript allows sunk costs to vary across plants with differences in size, location, previous cxperience, and other plant characteristics.5 To collapse these earnings pcwsibilities into a single expression, define the indicator variable Yi to take a value of 1 if the plant is exporting in period t, and 0 otherwise. Also, let the exporting history of the plant through period t be given by Yki, = (Y,, I j=O...J 3, where J1 is the age of the plant. Tben period t exporting profits are: Rsd2i;') = r p - F