# **1 Introduction**

While the argument that trade policy affects competition is an old one (see e.g. de Melo and Urata, 1986), there is to date little systematic evidence on how trade policy affects market power at the level of the firm and, in particular, how the effects of different trade-policy instruments play out. In a heterogeneous-firms setting, non-tariff measures (NTMs)—a widely used class of tradepolicy instruments including e.g. technical or sanitary regulations—affect market structure in ways that are not isomorphic to tariffs. Rather than merely shifting rents from foreign to domestic firms, they also change market structure by affecting firms differently depending on their size. For instance, a regulation may inadvertently create barriers to entry which generate a dominant position. Evidence of such effects of tariffs and NTMs is scarce, however, because assessing the market power of firms and how it relates to trade policy requires estimating indicators such as price-cost margins or market shares in well-identified markets. Both the identification of these measures and the definition of a market (and its structure) are problematic, which is why research has so far limited itself to specific sectors, countries, and trade policy instruments.

This paper follows a different route and identifies market power and how it is affected by trade policy using insights from the pricing-to-market (PTM) literature. We rely on a growing literature that establishes, theoretically and empirically, that the extent of firm-level PTM relates to firm size, efficiency and, ultimately, market power.<sup>2</sup> PTM implies that a firm faced with a cost shock will adjust its price differentially across destination markets, depending on the price elasticity of demand it perceives on each of them, which in turn depends on its market power. However, neither cost shocks nor market shares are observed directly at the firm level.<sup>3</sup> Our identification strategy goes around this by relating firm-level export prices (on which we have data) to bilateral exchange rate shocks.

Consider a firm faced with a series of bilateral exchange rate shocks, one on each of its destination markets. If it passed through the entirety of each shock onto consumer prices, its producer price in the home currency would remain the same irrespective of destinations; there would be no PTM. However, with incomplete pass-through, a fraction of each shock is absorbed by the firm into its producer price; as a result, the uniqueness of the producer price breaks down, giving rise instead to a series of differentiated ones by destination. In other words, the firm prices to market. Like in the case of a symmetric cost shock, the reaction of a firm’s producer price to an exchange rate shock tells us something about the elasticity of demand it perceives on its destination market—i.e., about its unobserved market power. Specifically, a firm with strong market power in a given destination (hence a low perceived price elasticity of demand) will absorb a large fraction of the bilateral exchange rate shock, and conversely. As destination markets vary in terms of their trade policy, we can then infer the effect of trade policy on market structure by observing the pricing behavior of firms exporting there, without directly needing to observe their market shares or any other measure of market power.

We start by discussing the impact of trade policy instruments on PTM in the destination country using a class of heterogeneous firms models featuring variable and endogenous markups.

> 2See for example Krugman (1986), Feenstra _et al._ (1996), Atkeson and Burstein (2008), Berman _et al._ (2012), Auer and Schoenle (2016), or Amiti _et al._ (2014).

> 3Market shares are not even observed at the more aggregated product level, as domestic firm sales are typically not observed.

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