# **1. Introduction**

Regional Trade Agreements (RTAs) have spread rapidly around the world since the 1990s and Latin America is no exception. Today all countries in the region are signatories of at least one RTA. This new economic environment has created both new challenges and new opportunities for exporters in the region. Yet, despite its importance to policy makers, exporters’ dynamics following an RTA have been underdocumented. Previous studies on RTAs have looked at their effects on export flows and especially at the trade creation and diversion effects (for a theoretical and empirical review see Freund and Ornelas, 2009). These studies use product, sectoral or country level data and thus provide little insight as to the effects on exporters’ activities and performance. Using a novel firm-level dataset of trade transactions for the Dominican Republic (DR) covering the period 2002-2009, we examine exporters’ responses to the Dominican Republic–Central America Free Trade Agreement (DR-CAFTA). The agreement entered into force in 2007<sup>1</sup> and includes the United States – DR’s main trade partners, Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua. We test whether DR-CAFTA has had a positive impact on the extensive margin, that is, whether it has increased exports through the entry of new exporters and the introduction of new product-market relationships. Finally, we also analyze whether the agreement has improved exporters’ survival in foreign markets.

The adjustments across the four margins (i.e. firms, products, markets and survival) are particularly important. First, exports generated by the entry of new firms and the introduction of new products/or markets are not only a source of growth but also of export diversification, both key elements of a country’s development strategy. Second, exporters’ survival in foreign markets is crucial for sustained export growth. Finally, it is essential to understand the effects of market access on exporters in order to design policies aiming at helping exporters reap all the benefits from trade liberalization.

For our analysis, we follow the theoretical frameworks outlined in Melitz (2003) and Bernard, Redding and Schott (2009). Melitz’ influential paper describes firms’ dynamics following trade liberalization. In his framework, firms differ in their productivity (i.e. marginal costs) and have to pay a fixed cost to enter the export market, thus implying that only the most productive firms will export. One of the main implications of the model is that a reduction in trade costs (i.e. tariffs) will lead to the entry of new exporters, as more firms will be able to afford entering the export market. An indirect implication of the model is also that lower tariffs will raise the profits of incumbent exporters, thus increasing their likelihood to stay in the market and decreasing their exit rates. Bernard, Redding and Schott (2009) refine the Melitz model to account for multi-product and multi-destination firms.<sup>2</sup> In their framework, a decrease in variable trade costs induces surviving exporters to start selling products which before were not

> 1 The agreement was signed in 2004 but it was only ratified in 2007. Compared to earlier agreements with the U.S., the CBI (Caribbean Basin initiative) and the CBTPA (Caribbean Basin Trade Partnership Act), the DR-CAFTA covers almost all products and, unlike its predecessors, is based on reciprocal trade preferences. In 2008, the DR trade policy with the European Union also changed. The Cotonou agreement which granted non-reciprocal trade preferences to the DR was replaced by Economic Partnership Agreements (EPA), a reciprocal trade regime.

> 2 Their setup generates not only firm selection but also product selection by the inclusion of a product-market fixed cost.

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