Price and Quality Dynamics in Export Markets∗

This paper investigates the evolution firm-level price and quality choices in export markets. We develop a model of heterogeneous firms who make endogenous entry decisions across distinct international markets. In each year, firms endogenously choose its optimal price and product quality to a build customer base in each market. Consistent with existing research, more productive firms in our model produce higher quality products, charge higher prices, sell more units and achieve higher profits. However, in our model firm-level quality, price and revenues endogenously evolve over time. New exporters optimally charge relatively low prices and produce low quality goods upon initial entry into export markets. As sales grow exporters upgrade product quality and prices to exploit their brand reputation and charge higher prices. We structurally estimate the model using detailed Chinese customs data. Our results indicate that dynamic considerations reduce predicted export prices upon initial entry into new markets by 1 percent. However, both product quality and prices are predicted to be 6-7 percent higher than that predicted by the static model five years after initial entry into export markets. The estimated model indicates that while new exporters often produce relatively low quality and inexpensive goods, product quality and prices rise among surviving exporters in subsequent years. ∗The authors thank the seminar participants at the Midwest Trade Meetings in Ann Arbor. †Department of Economics, Vanderbilt University, VU Station B #351819, 2301 Vanderbilt Place, Nashville, TN 37235-1819; Tel. : +1 615 322 2871; fax: +1 615 343 8495. Email: joel.b. rodrigue@vanderbilt.edu. ‡Department of Economics, Nanjing University, Nanjing, China. Email: yong.tan@vanderbilt.edu How do firms successfully grow in export markets? While encouraging exporting plays a prominent role in the development plan of many emerging markets, how small, new entrants successfully evolve into large, established exporters remains an open question. This paper investigates the evolution of firm-specific prices, product quality and sales in export markets. In particular, we document that differences in past firm performance strongly influence the evolution of future firm prices, product quality and sales in a given product market. We build a parsimonious, dynamic model where firms optimally chooses prices and product quality to maximize the long-run growth of the firm. The model is structurally estimated using a rich set of Chinese customs data. Using the structurally estimated model we are able to disentangle static and dynamic pricing incentives. Our preliminary results indicate that dynamic considerations reduce predicted export prices upon initial entry into new markets by 1 percent. However, product quality and prices are also predicted to be 6-7 percent higher than that predicted by the static model five years after initial entry into export markets. The estimated model suggests that while new exporters often produce relatively low quality and inexpensive goods, product quality and prices rise among surviving exporters in subsequent years. Our model relies on a rich literature which describes, documents and predicts firm-level input and output quality choices, their relationship with pricing decisions and the impact these have on firm profitability. In fact, our dynamic framework builds directly on the associated static models developed by Verhoogen (2008), Baldwin and Harrigan (2011), and Manova and Zhang (2012a). Not surprisingly, our theoretical structure captures many of same, well-known cross-sectional patterns. However, the dynamic nature of our model allows us to investigate the intertemporal, within-firm tradeoffs associated with entry and growth in new export markets. There is mounting evidence that idiosyncratic differences in product demand account for a large percentage of sales across markets (Foster et al, 2008; Gervais, 2012; Roberts et al, 2012; Hu et al, 2014). Our model provides a theoretical motivation for the source and growth firm-level demand heterogeneity: brand loyalty. Specifically, in our model firms endogenously choose their initial entry price and product quality to maximize long-run profits. Further, prices, quality and demand evolve together at the firm, product and market-level to reflect both the firm’s comparative advantage relative to its competitors and the preferences of consumers in a particular market. Specifically, products which provide “good value” high quality products for a given price to consumers tend to have higher initial sales. These firms, in turn, are able to exploit their brand reputation in later years to charge higher prices and markups. To quantify the dynamic implications of our model we draw on rich firm and product-level information from Chinese customs records. We observe physical sales and output prices of individual firms for every manufacturing export transaction between 2000 and 2006. This is matched with data capturing firm-level imports and import prices. We document three important features of this data. First, positive deviations from long-run average sales in the current year are strongly, positively correlated with positive deviations from long-run average sales in future