Imported Intermediate Inputs, Export Prices, and Trade Liberalization

This paper examines how trade liberalization affects unit value export prices via firms’ import decisions on input quality and the number of imported varieties. The paper extends Melitz’s (2003) model of trade with heterogeneous firms by introducing endogenous quality and endogenous number of imported varieties. The key predictions are as follows. First, an increase in productivity or a reduction in import tariff induces firms to spendmore on each import variety, and choose to import higher-quality inputs (the “quality effect”). Second, higherproductivity firms or firms facing lower import tariff tend to importmore varieties (the “variety effect”). Third, more importantly, due to the quality effect and the variety effect, there is a clear pattern of “quality ladder”: firms importing more varieties or with higher productivity set higher export prices; trade liberalization further raises export prices set by firms. However, if one adopts the alternative assumption that quality is exogenous across firms, then completely opposite results would be expected: import tariff reduction would decrease export prices, and firms importing more varieties or with higher productivity set lower export prices. We test two competing theories using the merged Chinese firm-product trade data and the tariff data at the HS8 level by computing firm specific tariff. Our empirical results strongly support all the predictions of the endogenous-quality model, validate the mechanisms of the quality effect and the variety effect, and therefore confirm the pattern of the “quality ladder”. Moreover, we find evidence to support the exogenous-quality model using quality-adjusted price estimates and the subsample of the goods with more homogeneity of quality