RESEARCH AND ANALYSIS
Are preferential agreements stepping stones to other markets?1
Ana Cristina Molina
Since 1990 the number of preferential trade agreements (PTAs) has increased dramatically, going from 17 to 202 in 2011.2 Although this surge is relatively recent, the effects of PTAs have been examined for over sixty years (see Viner, 1950, and for a review of the literature see Freund and Ornelas, 2009). The majority of studies has focused on the direct effects of PTAs (i.e. trade diversion and creation effects) and typically ignore their indirect effects. Yet, a PTA can also have a positive indirect effect – or spillover – on the exports to third countries by reducing, through different mechanisms, exporters’ costs of breaking into other markets.
Both theoretical and empirical studies about possible spillovers remain scant. While recent trade models with firm heterogeneity highlight the direct trade creation effects of PTAs, they do not capture the effect on the exports to third nations. These models predict that firms will start exporting to a market where tariffs are reduced (see Melitz, 2003) and thus imply that the number of new products exported (i.e. expansion of the extensive margin) to a newly-created PTA area should increase. Yet, once a product is introduced in the preferential area, it is likely that exporters will seek to expand and sell the same product to others markets outside the bloc. Indeed, recent evidence shows that most exporters start selling in a single destination and then, conditional on their survival, expand progressively to other markets (see inter alia Alvarez et al., 2007; Eaton et al., 2007).
We identify three mechanisms that could explain this process of expansion to markets outside the preferential area: (i) the presence of economies of scale at the production level (i.e. fixed production costs); (ii) the existence of learning effects (i.e. ‘learning by exporting’); and (iii) the presence of economies of scale at the export level (i.e. export entry costs).
The first case highlights the importance of market size for profitability. In many countries the consumer base is often too small to favour goods whose production is characterized by increasing returns to scale. In these cases, firms cannot produce profitably as they cannot generate the necessary sales to cover their fixed costs. By enlarging the home market, a PTA therefore makes the production of such products more attractive inside of the preferential area (see Krugman, 1980; Helpman and Krugman, 1985, chap. 10). Firms will produce within the bloc and then export to countries outside the bloc, thus making the preferential area the base for exports to countries outside the bloc as suggested in Baldwin et al. (2003, chapter 14).
Learning by exporting - the second expansion mechanism - suggests that firms improve their productivity as a result of their presence in export markets. Thanks to their interaction with foreign competitors and international buyers, exporters are exposed to new technologies (i.e. technology transfer) and greater expertise, which can help them to improve their manufacturing processes, reduce production costs and upgrade quality. If exporting to the PTA area improves firm’s productivity through learning by exporting, it can encourage entry into third markets. In fact, recent studies find that firm’s productivity and the number of markets it serves are positively correlated (see inter alia Eaton et al., 2008; Amador and Opromolla, 2008; Lawless, 2009; Bernard et al., 2009).
Finally, the existence of fixed entry costs into export markets can generate economies of scale in the export process and thus explain the expansion into third markets. These export entry costs include those associated with learning about export and customs procedures, markets and consumer tastes, and establishing distribution channels. Improved market access can help exporters to overcome these fixed costs. Once those are paid, the average cost of exporting the same product to additional destinations is lower, as predicted in Borchert (2007). Export experience can also reduce the uncertainty about a new market (Nicita et al., 2003), which in turn may reduce the fixed costs associated with entering new markets.
Through these mechanisms, PTAs can provide a ground for export experimentation, where exporters can develop their competencies, enhance their productivity and/or benefit from economies of scale. All of these can reduce the costs of breaking into third markets and therefore promote market diversification.3
To test the existence of such spillovers, we first look at the effect of exporting a product to the PTA area on the probability of subsequently exporting the same product to a market outside the preferential area. Our analysis employs trade data for 36 countries at the SITC 5-digit level and covers eleven South-South and South-North PTAs over an 11-year window. We find that a previous experience in a member market does increase the probability of exporting to a third country. We then examine how this effect changes with the entry into force of the agreement. Our results suggest that there exists a positive externality associated with the PTA. In our estimations, a previous experience in the PTA area has an additional positive effect on the probability of exporting to a third country in the years that follow the agreement. Furthermore, our results show that the size of the effect varies across PTAs.
Although the precise channels of influence require further study, we find evidence that, by boosting exports of new products within the preferential area, PTAs can trigger certain expansion mechanisms and therefore act as stepping stones to other markets.
Alvarez, R., H. Faruq and R. Lopez (2007). “New Products in Export Markets: Learning from Experience and Learning from Others.” Mimeo.
Amador, J. and L. D. Opromolla (2008). “Product and Destination Mix in Export Markets.” Banco de Portugal, Working Paper 17/2008.
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Borchert, I. (2007). “Preferential Trade Liberalization and the Path-Dependent Expansion of Exports.” University of St. Gallen, Department of Economics, Discussion Paper No. 2007-06.
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Helpman, E. and P. Krugman (1985). Market Structure and Foreign Trade, MIT Press, USA.
Krugman, P. (1980). “Scale Economies, Product Differentiation, and the Pattern of Trade.” American Economic Review, 70, 950-959.
Lawless, M. (2009). “Firm export dynamics and the geography of trade.” Journal of International Economics, Elsevier, vol. 77(2), pages 245-254.
Melitz, M. (2003). “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity.” Econometrica, Econometric Society, vol. 71(6), pages 1695-1725.
Nicita, A., M. Olarreaga and Soloaga I. (2003). “The Region as an Export Platform to the World? The Case of Mercosur.” Cuadernos de Economía (Latin American Journal of Economics), Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 40(121), pages 442-451.
Viner, J. (1950). “The Customs Union Issue.” New York: Carnegie Endowment for International
1. This note is based on Molina, AC (2010). “Are Preferential Agreements Stepping Stones To Other Markets?” IHEID Working Papers 13-2010, The Graduate Institute of International Studies. Back to text
2.S ource: WTO, RTA database. Back to text
3. It is worth noting that while the first mechanism is specific to the creation of a larger market and thus of a preferential area, the two other mechanisms provide a more general explanation for market expansion. Back to text
Ana Cristina Molina is an economist in the WTO’s Regional Trade Agreements Division. She has been working extensively on trade and development issues. Her areas of research include regional integration, export survival, trade diversification and competitiveness. Among her previous assignments, she worked as a consultant for the World Bank and UNCTAD. A native from Ecuador, Ms. Molina holds a Master and a Ph.D. in Economics from the Graduate Institute in Geneva.