Trade costs, import penetration, and markups

The rise of market power in recent decades has received increased attention, but the determinants of such a rise remain unclear. This paper studies whether and how increasing import penetration of inputs leads to a more concentrated market structure and the associated rise of markups. The use of quadratic preferences in combination with the inclusion of the firm’s choice to import create a link between the use of imported inputs and markups. A reduction in importing costs induces non-importers to start importing intermediates. Yet, the effect on profits is shaped by a trade-off between the potential marginal cost advantage and the fixed cost incurred from importing. As a result, only the most productive firms benefit from globalization, while existing importing firms do not fully pass through the reduction in trade costs using prices. The selection of importers, cost-savings from imported inputs and industry firm turnover jointly explain the rise of average markups in the market. Guided by this theoretical framework, we combine firm-level panel data, sector-level trade data and input-output tables to present empirical evidence on the relationship between the increase in imported input penetration and the rise of market power in the US over the last four decades. Using six-digit sectors as the unit of observation, we show that imported input penetration is positively associated with the size of markups.We test the model predictions on both the import decisions of heterogeneous firms and its implications for market structure. A difference-in-difference exercise that exploits China’s accession to the WTO and the use of input tariffs as a proxy for imported input penetration provide additional supporting evidence. Overall, we find that average industry markups would have been around 1.4% lower each year in the absence of imported inputs