We test the following:

**Testable prediction 1** _(Non-tariff measures and PTM): If NTMs increase fixed compliance costs for all firms, they reduce the degree of exchange-rate pass-through and raise the extent of pricing to market._

Now consider the case of tariffs. Assume that a firm exporting a product to both destinations faces a tariff in market 2, none in market 1. Except for the tariff in market 2 there is no other asymmetric trade cost and the two destinations are identical. Tariffs in destination 2 are ad-valorem and discriminatory, i.e. they apply only to home firms. The effect of such tariffs is isomorphic to an increase in the marginal costs of all home firms exporting to destination 2. Tariffs have thus two effects on market shares: First, they have an extensive margin effect whereby they displace small home competitors in favor of the largest remaining firms, both home and destination 2 firms. This implies that for the remaining home firms the market shares increase. Second, tariffs increase the foreign price of home-produced goods in destination 2, which decreases the demand faced by home firms and their market share. In net, the effect of a tariff in destination 2 on home firms’ market share, perceived elasticity of demand and PTM is indeterminate.

**Testable prediction 2** _(Tariffs and PTM): The effect of tariffs on the degree of exchange-rate pass-through and thus on the extent of pricing to market is indeterminate._

The effect of tariffs on PTM is thus an empirical question. However, a key difference with nontariff measures is that tariffs are discriminatory in nature while NTMs are not (WTO’s national treatment clause). Tariffs are then more likely to displace foreign firms in favor of domestic ones, implying that the intensive margin effect dominates and in net tariffs reduce the market shares of exporters and thus their incentive to engage in PTM. In the empirics, we will verify that this is indeed the case using our large dataset of developing and emerging countries.

# **2.3 Discussion**

Note that our assumption is that NTMs increase fixed compliance costs, however in principle NTMs could also affect variable costs, for instance if firms need to pay a higher price for their inputs. In that case the effect becomes similar to that of a tariff. This would decrease both the number of firms and their size. However, contrary to tariffs, because NTMs are non-discriminatory, the extensive effect might dominate and market power might increase for non-exiting firms – we would observe in this case more PTM. NTMs could also take the form of per unit costs, for instance if firms need to pay inspection costs per unit sold in the destination country. In that case, assuming as in Corsetti and Dedola (2005) that these additional per unit costs are paid in the currency of destination 2, the presence of NTMs would now also reduce the firms’ perceived elasticity of demand in market 2. The extensive margin effect together with the effect on the elasticity of demand may likely dominate, leading to more PTM for non-exiters. In both cases, because NTMs increase _variable_ costs, they should affect market power and PTM through the intensive margin of trade. However, in Section 6, we will verify that NTMs are mostly associated with changes at the extensive margin of trade.

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