FAMILIARITY, FIXED ENTRY COSTS AND ADJUSTMENTS ON THE EXTENSIVE MARGIN

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1 FAMILIARITY, FIXE ENTRY COSTS AN AJUSTMENTS ON THE EXTENSIVE MARGIN - an empirical analyi of unilateral export flow by Martin Anderon Ψ martin.anderon@jib.hj.e Abtract Fixed entry cot play an important role to explain the oberved heterogeneity among exporter in term of the extent of their export activitie. Yet, the exiting literature ha paid little attention to the nature and variation of uch cot acro different market. Thi paper propoe a link between familiarity and fixed entry cot, uch that (all ele equal) the cot of entering a familiar market i lower than entering an unfamiliar one. A tetable implication of thi i that familiarity hould primarily affect the extenive margin (number of exporter) of export. Thi hypothei i teted by etimating a gravity equation on a panel that decribe Swedih firm export to 150 detination countrie over a period of even year. The reult are conitent with the hypothei and how that the effect of familiarity on the volume of aggregate export i excluively due to adjutment on the extenive margin. The adjutment on the extenive margin are large and have a ignificant impact on aggregate export volume. The finding do not only help to clarify the nature and variation of fixed entry cot acro detination market: they alo ugget a precie mechanim through which familiarity affect trade. JEL claification: F10, F14, R12 Keyword: international trade, fixed entry cot, tranaction cot, gravity, extenive margin, intenive margin, heterogeneity Ψ Affiliation: Jönköping International Buine School (JIBS), Jönköping, and Centre for Science and Innovation Studie (CESIS), Royal Intitute of Technology, Stockholm. Addre: JIBS, P.O Box 1026, SE , Jönköping, Sweden. Phone (fax): ( )

2 1. INTROUCTION Firm-level dataet from different countrie reveal trong heterogeneity acro firm a regard their export activitie. Mot firm do not export and thoe that do typically only export to a limited et of detination countrie 1. Recent theoretical model Melitz (2003), Helpman et al (2004), Helpman et al (2005), Chaney (2006) and Eaton et al (2005) have hown that market-pecific fixed entry cot combined with difference in the underlying characteritic of firm can explain not only why not all firm export, but alo the oberved heterogeneity among exporting firm in term of the extent of their market penetration. Fixed entry cot imply that every market i aociated with a productivity threhold, uch that for each market firm elf-elect into exporter veru non-exporter. A merit of thee model i that they provide a theoretical foundation for why export flow partly adjut on the extenive margin (number of exporter). epite the ignificance acribed to fixed entry cot 2 the exiting literature ha paid little attention to explanation of the nature and variation of uch cot acro different market, neither in empirical nor theoretical tudie. However, the oberved diparitie in the extenive margin between countrie unilateral export flow ugget that firm do incur fixed entry cot market by market. An undertanding of how and why the magnitude of uch entry cot varie acro detination, therefore, i neceary to explain variation in the extenive margin and thu variation in marketpecific export flow. By adhering to baic tranaction-cot theory thi paper propoe that the magnitude of fixed entry cot are related to familiarity, uch that the fixed entry cot i lower if the (potential) exporter are familiar with the detination market. The main motivation for thi i twofold. Firtly, the cot aociated with contractual agreement are typically unk cot, i.e. a ignificant part of them are incurred before the actual trade take place and they are irreverible 3. Secondly, contractual incompletene i the norm rather than the exception and familiarity encompaing informal and formal intitution uch a culture, judicial ytem and buine ethic can compenate for incomplete contract (Hart & Holmtröm 1987). The role of familiarity in trade ha a long tradition. Gravity etimation typically confirm that familiarity augment trade (ee e.g. Huang 2006, Anderon 2000, Loungani et al 2002, Johanon & Wetin 1994ab, Hacker & Einaron 2003). A familiarity ha an evident geographical component, familiarity ha alo been advanced a a potential explanation for the mytery of the miing trade (Trefler 1995). Anderon (2000), for intance, maintain that there mut be extra tranaction cot on top of tranport cot, ince actual trade barrier and tranport cot are too low to account for the difference between the ize of oberved trade flow and the prediction from tandard model. The etimated effect of ditance in gravity model are typically too large given the ize of actual tranport cot (Groman 1998, Hummel 2001). Yet, notwithtanding the well-documented effect of familiarity on trade, hitherto the mechanim by which familiarity enhance export ha to a large extent remained unreolved. A relationhip between familiarity and fixed entry cot doe not only help to clarify the nature and variation of fixed entry cot; it alo ugget a precie mechanim through which familiarity affect trade. If higher familiarity tranlate into to lower fixed entry cot, the trade-augmenting effect of familiarity on aggregate trade flow hould primarily repreent adjutment on the extenive margin (number of exporter). The fixed entry cot enter in the deciion of whether to export or not to 1Stylized fact are reported in inter alia Cleride et al (1998), Bernard & Jenen (1995, 1999), Bernard et al (2003). See in particular Eaton et al (2004) and Anderon (2006) for data on the heterogeneity among exporter in term of the extent of market penetration. 2 Without fixed entry cot, productivity threhold cannot be defined. However, Eaton et al (2005) remark that fixed entry cot i not enough to explain the pattern decribed by data. Both tranport cot and fixed entry cot are needed, (ibid. p 3). 3 Sunk cot are fixed cot, but fixed cot need not necearily be unk. Both unk and avoidable fixed cot lead to productivity threhold, but fixed avoidable cot are relevant for hutdown and exit deciion wherea unk cot are not (c.f. Baumol & Willig 1981). Sunk cot aociated with entry cannot be recovered on exit. 2

3 a given market, but not in the deciion of how much to export ince the fixed entry cot i already paid. The paper tet thi hypothei on a panel dataet over even year ( ) of Swedih firm export to 150 detination countrie. The empirical trategy i a follow: Firtly, aggregate export flow (i.e. the um of all exporting firm export) from Sweden to each detination country are etimated uing a one-ided gravity model, including dummy variable for familiarity. Thee etimate are ued a benchmark. Secondly, aggregate trade flow to each detination country and year are decompoed into (i) an extenive margin (number of firm) and (ii) an intenive margin (export per firm), in manner akin to Hummel & Klenow (2005). Then both component are etimated uing the ame model. Thi allow for an aement of the enitivity of each margin to the righthand-ide (RHS) variable in the empirical model. Variable that only have ignificant effect on the extenive margin hould pertain to the magnitude of fixed entry cot. The paper alo tet whether there are difference in the reult between differentiated product and product with reference price, uing the product claification developed by Rauch (1999). The contribution of the paper i not to how that familiarity affect trade. Rather, the novelty i that it (i) link fixed entry cot to familiarity and (ii) conduct an empirical tet by analyzing how the extenive and intenive margin, repectively, adjut to the RHS variable in a gravity equation. The remainder of the paper i organized in the following fahion: Section 2 preent the theoretical framework. It tart by illutrating how the aumption of fixed entry cot aociated with each market tranlate into market-pecific productivity threhold by the uing the baic tructure of a model utilized by Helpman et al (2005) and Chaney (2006). Thi ection provide a theoretical motivation for the empirical trategy in the paper. It then dicue the nature of fixed entry cot and outline how uch cot are related to familiarity by adhering to baic tranaction-cot theory. Section 3 preent the data. The empirical methodology i motivated and dicued in Section 4. The reult of the empirical analyi are preented in the ame ection. Concluion of the paper are preented in Section FAMILIARITY AN AJUSTMENTS ON THE EXTENSIVE MARGIN 2.1. Entry cot, productivity threhold and the extenive and intenive margin of unilateral export flow The magnitude of a country export flow to a pecific market depend on the ize of two baic component: (i) number of exporting firm and (ii) export per firm. The firt component i referred to a the extenive margin and the econd to the intenive margin. Variation in unilateral export flow can therefore be acribed to adjutment on each repective margin. Recent contribution Eaton et al (2005), Helpman et al (2004), Helpman et al (2005) and Chaney (2006) have made progre in explaining why and how trade flow adjut on each of the margin. In thee model, the rationale for an extenive margin that vary acro market tem from a combination of market-pecific fixed entry cot and firm heterogeneity a regard productivity. Fixed (unk) entry cot imply that each foreign market i aociated with a productivity threhold and a non-uniform ditribution of productivitie acro firm explain why the number of exporter (the extenive margin) differ from market to market. While both the extenive and the intenive margin vary with variable export cot and market ize, fixed entry cot only affect the extenive margin. To illutrate the baic relationhip and provide a motivation for the ubequent empirical trategy, Table 1 preent the eential tructure of the monopolitic competition model ued by Helpman et al (2005) and Chaney (2006). 3

4 Table 1. Baic tructure of the model in Helpman et al (2005) and Chaney (2006), which yield an intenive and extenive margin of unilateral export flow. ecription Expreion Explanation of variable Utility of conumer in market r Tranportation cot (iceberg) between r and σ σ 1 σ 1 σ i U r = z, σ > 1 i N r t > 1 = 1 r zi = conumption of product i, produced by firm i (each firm produce a ditinct product) Nr= number of product in market r (dometic + imported) t rr - Fixed (unk) entry cot from r to F > 0 F = 0 - r rr Cot of exporting to market for firm i conditional on a location in r, ci, β c + F i, = trzi, γi r β = marginal production cot (ame acro all firm) γi = firm i productivity (firm-pecific) Fr= fixed entry cot from r to zi, = firm i export (in volume) to The aumption in the table imply an extenive and an intenive margin of unilateral export flow. Each margin in partial equilibrium i given below. The profit to firm i, located in r, from exporting to π market,, i, i given by: β γ (1) π i = ~, pi, zi, tr Fr i where pɶ i, i the c.i.f price of firm i product in market and the other variable are a in Table 1. Setting π i, = 0, utilizing the demand function and the pricing rule that follow from the aumption in the table and olving for productivity, γ i, yield the productivity threhold (in partial equilibrium) a regard export to market from r, γˆ r: (2) ˆ γ r = α Y 1 F σ 1 r tr P where α i a election of contant parameter (including the marginal cot of production) and P denote the ideal price index in market. The expreion in (2) hold for all r and determine the productivity neceary for the gro profit of the export flow to recover the fixed entry cot. The productivity threhold i a function of characteritic in the detination market (Y, P) and factor that pertain to the link between and r, (tr, Fr). It increae with the ize of the fixed entry cot Fr, but decreae with Y. Thu, all ele equal, larger market have lower productivity threhold, becaue ale revenue are larger in larger market. Moreover, the threhold to ditant market i larger than to proximate market becaue of tranport cot and market with higher price indexe naturally have lower productivity threhold. All firm in r whoe productivity i above γˆ r will export to wherea no firm whoe productivity i below γˆ r will export to. Given a location in r the productivity threhold aociated with foreign market 1, 2, 3, m can be ordered in ize uch that ˆr γ 1< ˆr γ 2< ˆr γ 3 < ˆrm γ. A firm with low productivity will then erve a limited number of market of low order, i.e. low productivity threhold, wherea firm with higher productivity can export to a larger number of market. Thi illutrate that the extenive-margin vary acro market with different productivity threhold. 4

5 The intenive margin (export per firm) from r to i given by: z γ γ γ γ = θ P Y i σ ˆ i, i i i tr 1 (3) ( ) σ where θ i a election of contant parameter (including the marginal cot of production). Whether a firm in r export to market i conditional on that it own productivity meet the productivity threhold aociated with. Both the extenive and the intenive margin vary with ditance, marketize and the price index. However, variable that pertain to fixed entry cot hould by definition only have a ignificant effect on the extenive margin, i.e. a pecific component of export flow Theoretical motivation for a relation between familiarity and fixed entry cot Tranaction cot and fixed entry cot Tranaction cot refer to cot of etablihing exchange agreement (Williamon 1979, Jokow 1985). North & Thoma (1973) categorize uch cot according the three conecutive phae in tranaction procee: (i) earch cot, (ii) negotiation cot and (iii) monitoring and enforcement cot. Before negotiation, a buyer mut collect information about available product, potential eller and the price and quality of their repective product. Once a (till potential) eller ha been elected, the partie negotiate about the term of the contract. Thi negotiation pertain to contractual liabilitie, obligation and penaltie, uch a type and time of delivery, product characteritic and form of payment. The third phae refer to cot aociated with monitoring and contract enforcement. Monitoring can be done, for intance, through inpection and aement of the delivered product. If the characteritic of the delivered product or the general behavior of one part deviate from the pecification in the contract, the olution i contract enforcement. A firm that ha entered a foreign market and initiated export ha by definition etablihed exchange agreement with cutomer in the market in quetion. A hown above, thee agreement are preceded by tranaction cot. Thee cot are unk and cannot be recovered even if the contract aociated with the exchange agreement i abandoned 4. They are irrevocably committed and fixed becaue they are paid before the actual delivery take place. Therefore, the fixed entry cot a firm need to pay to enter a foreign market depend on the cot of etablihing exchange agreement with cutomer in that market. Tranaction cot are generic in the ene they pertain to all exchange agreement irrepective of whether the agreement involve dometic or foreign partie. Thi generality i contructive for the characterization of fixed entry cot. The ditinctivene with export i that the tranaction cot aociated with entering foreign market are preumably higher than thoe aociated with the dometic market. However, albeit they are higher on average, their magnitude i not uniform acro foreign market. One reaon for thi i variation in familiarity Familiarity, tranaction cot and adjutment on the extenive margin Familiarity with a foreign market allude to familiarity with general characteritic that permeate the market. Intitution are typical uch characteritic and refer to contraint that tructure political, economic and ocial interaction (North 1990, p.97). Formal intitution include property right, 4Becaue of thi, high tranaction cot can provide an incentive to invet in durable interaction capacity, which point toward rigiditie and inertia in trading relation (Johanon & Wetin 1994b). However, a dicuion of arm length veru network relation i beyond the cope of thi paper. 5

6 judicial ytem and contitution. Informal intitution include norm, tradition and rule of conduct. Familiarity with the formal and informal intitution in a foreign market reduce uncertainty and barrier that pertain to information and communication. Lower information and communication barrier tranlate into lower cot aociated with earch and negotiation. Mutual familiarity allow for the realization of communication and information economie (Williamon 1979). Knowledge of the foreign language i a baic form of familiarity and eae communication in a direct ene. Therefore, it facilitate the development of familiarity with the intitution in the foreign market. Moreover, a familiarity i typically developed through repeated interaction it tend in addition to be correlated with trut (c.f. Gulati 1995). Thi implie that familiarity affect the cot that are due to uncertainty about future tate at the time of negotiation about the term of a contract. The tranaction-cot literature make a fundamental ditinction between complete and incomplete contract (Williamon 1979, Jokow 1985, Hart & Holmtrom 1987, Hart & Moore 1999). Complete contract are full contingent contract which encompa a pecification of the obligation of each part under all future contingencie. Incomplete contract, on the other hand, are imperfect in the ene that they do not unambiguouly pecify the dutie of each part in every poible tate of nature. A market condition change over time and uncertainty about future tate i the norm rather than the exception, complete contract are aociated with ubtantial cot. The cot of etablihing incomplete contract are lower, but uch contract bring about a potential for ex pot opportunim. Familiarity and trut can compenate for contractual incompletene (Hart & Holmtrom 1987), a mutual trut implie that the expectation ex ante of bad behavior ex pot are reduced. Put differently, the partie can accept a higher degree of contractual incompletene and thereby reduce tranaction cot when an exchange agreement involve environment which they trut and are familiar with. Familiarity ha a marked relation to geography. The familiarity with the informal and formal intitution in adjacent market i typically higher than in ditant market. Likewie, intitution a uch have a tendency to be more imilar between market that are located in proximity to each other, e.g. market that hare a common border. One reaon for thi i high interaction intenity over long time period. Becaue of it geographical component, familiarity ha been advanced a a potential explanation for the miing trade (Trefler 1995). Extra tranaction cot that are correlated with ditance on top of tranportation cot can explain why the etimated effect of ditance in gravity etimation are too large, given the magnitude of actual tranport cot, (Groman 1998, Anderon 2000). Several tudie have hown that factor pertaining to familiarity have an impact on trade, (ee Anderon 2000 and Loungani et al 2002 for overview of the literature). A typical way in which the effect of familiarity i teted i to include dummy variable in gravity equation that repreent a preumed familiarity and affinity (ee e.g. Frankel & Roe 2002, Johanon & Wetin 1994a, Hacker & Einaron 2003). In a recent tudy, Huang (2006) extend thi type of analye by making ue of Hoftede (1980) uncertainty averion index. The reult how that uncertainty-avere countrie trade le with countrie they are unfamiliar with. Although the conenu in the literature i that familiarity doe augment trade, the mechanim() by which it doe o ha to a large extent remained unreolved. The link between fixed entry cot, tranaction cot and familiarity decribed above ugget that familiarity hould primarily repreent adjutment on the extenive margin, i.e. a pecific component of unilateral export flow. In what follow, thi hypothei i teted empirically by etimating a one-ided gravity model and eparating between the extenive (number of exporter) and intenive (export per firm) margin (c.f. Hummel & Klenow 2005, Anderon 2006) of Sweden unilateral export flow to 150 detination countrie over a equence of even year. 6

7 3. ATA AN ESCRIPTIVES 3.1. ecription of data ource A ditinction between the extenive and intenive margin i made poible by Swedih manufacturing firm-level export data, obtained from Statitic Sweden (SCB). Thee data cover the period and report each firm export by detination country. Firm correpond to legal entitie and are identified by a unique identity number. The number of exporter to a given detination country i then the election of firm that have regitered (i.e. poitive) export to that country. ata on GP, GP per capita and ditance were obtained for 150 detination countrie. GP and GP per capita, adjuted for purchaing power parity (PPP), are extracted from World evelopment Indicator (WI) 2005 and are meaured in contant US $. itance in kilometer from Sweden to the repective detination countrie are computed uing the latitude and longitude coordinate of the capital in each detination country and the capital of Sweden. The ditance in kilometer are then given by the circle-formula, which are baed on the phere of the earth and give the minimum ditance along the urface Illutration of the data and decriptive tatitic The Swedih data reveal triking difference in the number of exporter between different market. For intance, the number of exporter to Norway, which hare a common border with Sweden, i about three time a large a the number of exporter to the US although the Norwegian market in term of GP i only 2 % of the US market. In order to provide the reader with a feel for the data, Figure 1 illutrate a et of baic relationhip between GP, ditance and the extenive and intenive margin, repectively. The relationhip are baed on average figure are expreed in log and are conitent thoe reported in Eaton et al (2004) on French export data. Figure a) and b) plot the relationhip between the number exporter (i.e. the extenive margin) to a detination country and the ditance to and GP of that country, repectively. Evidently, the number of exporter ytematically decreae with ditance and increae with market-ize. Figure c) and d) plot the relationhip between average export ale per firm to a detination country, i.e. the intenive margin of market-pecific flow, and ditance and GP repectively. Export ale per firm decreae with ditance and increae with GP. Table 2 preent decriptive tatitic of the mean value during the period of Sweden export and GP and GP per capita in the 150 detination countrie in the ample. Evidently, there i great variation in both total the export flow, the intenive and extenive margin acro the detination market. The ditribution i kewed to the right, a can be een form the difference between the mean and the median. A few detination countrie are aociated with a large number of Swedih exporter, a large intenive margin and large export flow, repectively. The ditribution of export flow acro pace i thu highly uneven. The data on GP and GP per capita are tandard and the ditribution decribed by the figure in the table i illutriou. 7

8 a) Number of exporter and ditance. b) Number of exporter and GP. c) Average export ale per firm and ditance. d) Average export ale per firm and GP. Figure 1. The relationhip between number of exporter, average export ale per firm, GP and ditance (all relationhip in log). Table 2. ecriptive tatitic of continuou variable in the empirical model, (figure baed on the variable mean value )* Variable Mean Median Export (in million US $) Std. deviation Max Min Extenive margin (# export firm) Intenive margin (in thouand US $) GP (in billion US $) GP per capita (in thouand US $) itance (kilometer) # ob *) The export data are from Statitic Sweden (SCB). GP and GP per capita are from World evelopment Indicator (WI) and are adjuted for purchaing power parity (PPP), expreed in contant US $. itance refer to the ditance in kilometer between Sweden capital city (Stockholm) and the capital city in each repective detination country. 8

9 4. EMPIRICAL ANALYSIS 4.1. Model pecification, empirical trategy and etimation iue Empirical model A hown in Section 2.1, both the extenive and the intenive margin are function of tandard variable in gravity model, uch a market-ize (GP) and ditance. Variable that affect each repective margin are relevant for explaining aggregate export, becaue total export to each market are given by the number of exporter and their average export. The empirical model i a one-ided gravity model. The volume of unilateral export flow from Sweden to a given detination country in each year i modeled a a function of GP, GP per capita, ditance and a et of dummy variable. The model i preented in (4): β cap φ Nordic Baltic Englih A, N Locked I (4) Xt, = αyt, ( Yt, ) exp{ λd + θ + ρ + ϕ + ς ξ γ } where X,t denote the total export volume from Sweden to detination country in year t. Y,t i GP cap (PPP adjuted, contant price) and Y t, i GP per capita (PPP adjuted, contant price). d denote the ditance (in kilometer) from Sweden to country. GP per capita reflect the purchaing power in a country. Moreover, it i alo a proxy for political tability and quality of intitution, (ee inter alia IMF 2003) 5. Becaue of thi, uncertainty and expected enforcement cot can be higher in countrie with low GP per capita. d denote the (time-invariant) ditance in kilometer from Sweden to country. Equation (4) implie an exponential ditance-decay function. Thi i motivated by that tranport cot per kilometer are more often than not lower for long-ditance haulage compared to hortditance one, i.e. the relationhip between tranport charge per ditance-unit and ditance i nonlinear. Thi can be explained by that the choice of mode of tranport, with different tranport charge per ditance unit, varie depending on length of haul. There are ix dummy variable in the model of which three have a direct bearing on familiarity. Thee three are: (i) a dummy for Nordic countrie, (ii) a dummy for Baltic countrie including Poland and (iii) a dummy for countrie with Englih a an official language. In addition, the model include dummie for Autralia and New Zealand, landlocked countrie and mall remote iland economie, repectively. The motivation and definition of each of thee dummy variable are preented in Table 3. The countrie repreented by the dummie for Nordic and Baltic (incl. Poland) are all countrie in geographical proximity to Sweden and are preumably familiar to Sweden. The Baltic countrie, including Poland, are relatively proximate and have colonial and hitoric tie with Sweden. The Nordic countrie have imilar language 6 and hare a common border in addition to a general geographical proximity. Englih repreent countrie with Englih a their official language. Thi et of countrie ha no direct relation to geographical proximity. However, knowledge of the language in the foreign market reduce communication and information cot and facilitate the development of familiarity with both formal and informal intitution. A noted in the table, although Englih i not an official language in Sweden, Englih tudie are mandatory in compulory chool in Sweden. The model in (4) alo include a dummy variable for landlocked countrie, Locked, which take the value 1 if the country ha no coatline and 0 otherwie. Hummel (1999) remark that about two third to three quarter of world trade (in term of value) are hipped via ocean liner. Thi i ugget that the hipment of good to a landlocked country, everything ele equal, are aociated with higher tranport 5 In addition, Knack (2001) report on a trong correlation between overall trut and GP per capita. 6 A oppoed to Norwegian and anih, Finnih and Swedih have different trait. Swedih i a Germanic language (included in the Indo-European language family) wherea Finnih i a Uralic language (not part of the Indo-European family). However, Swedih i an official language in Finland. 9

10 cot than non-landlocked countrie. Anderon & van Wincoop (2004), for intance, report that the median landlocked country ha on average 55 % higher tranport cot than the median coatal country. The coefficient etimate i thu expected to be negative for both the extenive and the intenive margin. New Zealand and Autralia are repreented by A,N. Thee countrie are located at the greatet ditance from Sweden, but are developed countrie with Englih a their official language. An additional dummy control for mall remote iland economie. Thee are mall market with typically undeveloped indutry that to a large extent rely on tourim. Given thee characteritic, they contitute a pecial cae. The coefficient etimate aociated with thi dummy variable i therefore expected to be negative. Table 3. Explanation and motivation for the dummy variable in (4). Variable Explanation Motivation Nordic 1 if country i a Nordic country, 0 otherwie Familiarity: common border, language imilaritie, cultural proximity, colonial tie Baltic 1 if country i a Baltic country (including Poland), 0 otherwie Familiarity: colonial tie (Etonia and Latvia), hitoric tie, proximity, previou tudie (e.g. Johanon & Wetin 1994b, Hacker & Einaron 2003) Englih 1 if Englih i an official language in country. Familiarity: communication cot, low linguitic ditance (Englih tudie are mandatory in compulory chool in Sweden) AN, Locked 1 if country i Autralia or New Zealand, 0 otherwie 1 if country i landlocked (no coatline), 0 otherwie Great ditance from Sweden but developed market with Englih a their main language. Higher tranport cot, ceteri paribu. Between ⅔ and ¾ of world trade i hipped by water (ocean) carrier (Hummel 1999). The median landlocked country ha about 55 % higher tranport cot than the median coatal country (Anderon & van Wincoop 2004). I 1 if country i a mall remote iland economy, 0 otherwie Special cae: mall market, tourit economie, remotene. Taking log on (4) lead to the equation to be etimated: (5) lnx = α + β lny + φ ln Y λd + θ + ϕ... cap Nordic Baltic t, t, t,... + σ + ς ξ γ + ε Englih A, N Locked I t, The equation decribe a panel data model with even time period ( ) and 150 group (detination countrie). In line with previou tudie, the parameter etimate for dummy variable that pertain to familiarity are expected to be ignificant and poitive. In order to tet the hypothei that their effect on aggregate export primarily i due to adjutment on the extenive margin, both the intenive and extenive margin are regreed on the right-hand-ide (RHS) variable in (5). If the 10

11 parameter etimate of Nordic, and Baltic Englih are only ignificant and poitive for the extenive margin but not for the intenive margin, it i conitent with the hypothei that the effect of familiarity on aggregate trade flow primarily repreent adjutment on the extenive margin. The eparation between the extenive and the intenive margin i made in the following manner: f = + lnxt, ln ( Xt, ft, ) lnx lnf lnx f (6) t, t, t, f where ft, i the number of exporting firm in Sweden that export to country in time t and x t, i the average export ale per firm to the ame country in the ame time period. Thu f t, i the f extenive margin and x t, the intenive margin. Regreing lnx t,, lnf t, and lnx f t, eparately on the RHS of (5) allow for an empirical aement of which of the two margin that account for the effect of the variable on aggregate market-pecific unilateral export flow. An underlying aumption in thi empirical trategy i that all firm that meet the productivity threhold aociated with a market export to the market. Etimation iue A the model in (5) only include three country-pecific variable GP, GP per capita and ditance it can be expected that there are heterogeneity among the detination countrie not accounted for by the RHS variable. Such heterogeneity can, for intance, be due to unoberved attribute of the link between Sweden and the repective detination countrie. A more apparent reaon for unoberved country-pecific effect i that the price-index in each repective detination country i omitted from the model. Unoberved heterogeneity can be controlled for by either a fixed or a random effect etimator (Greene 2003, Wooldridge 2002). A merit of the fixed effect etimator i that it i robut to correlation between the unoberved country-pecific effect and the independent variable. However, if a model include time-invariant independent variable, uch a ditance, thi robutne of the fixed effect etimator i of no ue becaue it cannot be applied regardle of whether it i etimated uing dummy variable or the within tranformation (c.f. Wooldridge 2002). The reaon i that it ue the variation over time within each group. Becaue of thi, Wooldridge (2002) maintain that the random effect etimator i an appropriate alternative. If there i no correlation between the unoberved grouppecific effect and the independent variable, the random effect etimator i more efficient than the fixed effect etimator becaue it ue more of the variation in the data, i.e. it ue both the variation within and between group. The fixed effect etimator can be imprecie if there i little variation in ome of the independent variable. Moreover, part of the (preumed) correlation between the independent variable() and the unoberved effect can be controlled for by including dummy variable for variou group (Wooldridge 2002, p.288). For thee reaon, the model in (5) i etimated with the random effect etimator. itance i time-invariant and the dummie for Nordic and Baltic countrie control for familiarity, which i preumably related to ditance. Furthermore, there i no pecific reaon to aume that the price-index in each repective country, which i omitted from the model, ha any particular correlation with the independent variable 7. In the random effect model, the error term in (5), t,, repreent a compoite error uch that: c u (7) ε, = +, t t ε 7 Chaney (2006) how that the endogenouly determined price index in a country (in general equilibrium) depend on it own ize and an index of it remotene from the ret of the world. A country remotene relative to Sweden can be expected to have a minor impact on each country index of remotene. 11

12 where c i a country-pecific random error and u t, i an idioyncratic error. c thu reflect unoberved heterogeneity acro detination countrie Reult aggregate unilateral export Table 4 preent etimate of the parameter in (5). The etimate reported in the table are obtained from a random effect etimator adjuted for erial correlation in the idioyncratic error. An adjuted Breuch & Pagan (1980) lagrange-multiplier (LM) tet how that the null hypothei of no random effect (i.e. country-pecific random error) can be rejected for each model. Likewie, Bera et al (2001) robut LM tet for erial correlation in the idioyncratic error how that the null hypothei of no erial correlation can be rejected 8. Each table alo report the etimated autocorrelation coefficient aociated with the repective etimation. The reult are in line with the expectation. The 3 rd column from the left in the table preent the reult obtained for aggregate unilateral export volume. The fit of the model for aggregate unilateral export i Total export to a detination increae with GP and GP per capita and decreae with ditance. The parameter etimate aociated with the dummy for Nordic and Baltic countrie and countrie with Englih a an official language are all ignificant and poitive. The magnitude of the etimated effect are large, economic ignificant and conitent with previou tudie of Swedih unilateral export (c.f. Hacker & Einaron 2004, Johanon & Wetin 1994a). The etimated parameter for Nordic ugget that, all ele equal, being Nordic increae Swedih export with a factor exceeding 10, ( exp{ 2.36} = 10.59) 9. Export to Baltic countrie (incl. Poland) are more than eight time larger than motivated by GP, GP per capita and ditance alone, ( exp{ 2.12} = 8.33). Englih a an official language almot double Swedih unilateral export, ( exp{ 0.67} = 1.95). It i alo evident that landlockedne ubtantially reduce export. All ele equal, export to a landlocked country i only 0.3 time a large a to a non-landlocked country, ( exp{ 1.15} = 0.31). A expected export to mall remote iland economie are on average lower, wherea AN ha no ignificant impact on aggregate unilateral export volume. What kind of adjutment give rie to thee effect on aggregate export? The 4 th and 5 th column from the left in Table 4 preent the parameter etimate obtained by regreing the extenive and intenive margin on RHS variable in (5), repectively. The reult for each repective margin how that it i excluively the extenive margin (i.e. number of exporter) that adjut to Baltic, Englih and Nordic. Thee variable do not have a ignificant effect on the intenive margin. Thi i conitent with the hypothei that familiarity pertain to the ize of fixed (unk) entry cot, a predicted from a tranaction-cot perpective. The effect of the dummie repreenting familiarity on aggregate unilateral export can thu be attributed olely to adjutment on the extenive margin. Given the decribed magnitude of the effect on aggregate export volume, adjutment on the extenive margin are important and can explain a ignificant part of the variation in aggregate unilateral export flow. Thi motivate and upport model which combine heterogeneou firm and market-pecific fixed entry cot. Although the etimated parameter aociated the dummy for New Zealand and Autralia i inignificant for aggregate export, it i ignificant and poitive for the extenive margin. 8 In addition, Baltagi & Li (1991) joint tet for random effect and erial correlation uggeted random effect and erial correlation in all etimation. 9 9 If detination 1 and 2 are imilar in all repect except that detination 1 i Nordic wherea detination 2 i not, the difference lnx lnx = x x = exp. A imilar in the volume of export to thee countrie according to the model in (5) i: θ { θ} interpretation applie to all dummie in (5)

13 Table 4. Sweden export to 150 detination countrie Etimate of parameter in (5), dependent variable: (i) export volume, (ii) extenive margin and (iii) intenive margin. a,b,c,d Variable Parameter Aggregate export flow (export volume) Extenive margin (# of exporter) Intenive margin (average export volume per firm) lny β 1.03* (15.74) 0.53* (13.11) 0.47* (7.55) lny cap φ 0.24* (1.96) 0.34* (5.07) -0.21** (-1.83) d λ * (-6.67) * (-4.24) * (-4.06) Nordic θ 2.36* (3.60) 2.24* (5.51) n. Baltic ϕ 2.12* (3.33) 2.29* (5.81) n. Englih σ 0.67* (2.72) 0.48* (3.12) n. ς n. AN, 0.92** (1.70) n. Locked ξ -1.15* (-4.39) -0.52* (-3.24) -0.68* (-2.74) I γ -0.86** (-1.93) -1.05* (-3.78) n. Adj. BP (var(c) =0) * * 67.70* BSY (AR1) * 41.99* * Etimated auto.corr ( ˆρ ) R # ob a) Etimate obtained from a panel data etimation of Swedih export to 150 detination countrie Random effect etimator adjuted for erially correlated idioyncratic error. b) * indicate ignificance at the 0.05 level, ** indicate ignificance at the 0.10 level. t-value preented within bracket. Inignifcant (level > 0.10) parameter etimate are denoted by n.. c) Adj. BP refer to the tet tatitic of an adjuted Breuch & Pagan (1980) lagrange multiplier (LM) tet for random effect, which work under erially correlated idioyncratic error; H0: ( ) 2 var c = σ =0, ee (7) in the main text. d) BSY refer to the tet tatitic of Bera et al (2001) robut LM-tet for erial correlation in the idioyncratic error, which work in the preence of random effect; H0: E ( ut,, ut, 1 ) =0, ee (7) in the main text. 13

14 The etimated effect of all individual variable in (5) on aggregate export flow can partly be attributed to adjutment on the extenive margin, i.e. difference in the number of exporting firm. In term of fit (R 2 ), the one-ided gravity equation predict the extenive margin much better than both aggregate export flow and the intenive margin. The R 2 indicate that the model explain 85 % of the variation in the extenive margin acro the detination countrie, but 26 % of the variation in the intenive margin. For the intenive margin, four variable GP, GP per capita 10, ditance and landlockedne have a ignificant impact. The negative and ignificant impact of landlockedne i in line with that landlocked detination are aociated with higher tranport cot, i.e. higher variable cot of exporting. However, none of the parameter etimate aociated with the other dummie i ignificant. The extenive margin i more enitive to GP and increae with GP per capita than the intenive margin. Thi can potentially be explained by the oberved correlation between the overall quality of formal intitution and the general level of economic development (ee IMF 2003), uch that the expected cot aociated with contract enforcement are lower in detination with higher level of economic development Robutne Variou method to ae the robutne of the reult preented in Table 4 were applied. The dependent variable aggregate export flow, the extenive and the intenive margin are kewed to the right, in the ene that the mean i much larger the median (ee Table 2). oe the reult remain robut if the parameter are etimated uing the conditional median of the dependent variable(), uch that the parameter are etimated by minimizing the abolute deviation? In Appendix A, the parameter etimate of the variable in (5) uing median regreion for (i) aggregate export flow, (ii) the extenive and (iii) the intenive margin are preented. Thee parameter are etimated with Koenker & Baett (1978) quintile regreion technique at the 50 th quintile, i.e. the median, on average figure with boottrapped tandard error, (ee Appendix for detail). A can be een from the Appendix, the reult prevail when etimated uing the conditional median of the dependent variable. Moreover, uing average figure , aggregate export, the extenive and intenive margin were regreed on the RHS variable in (5) uing a robut regreion technique 11. Thi procedure produced identical reult a thoe previouly reported, with the exception that the parameter etimate for GP per capita turned out to be inignificant. The final check of the reult i baed on the obervation that export product have different characteritic which are likely to have an impact on the cot of matching buyer and eller and the overall magnitude of tranaction cot. Rauch (1999) maintain that tranaction of differentiated product are in general aociated with more extenive earch and information gathering becaue of product-pecific attribute combined with lack of reference price. By empirically ditinguihing between product traded on organized exchange, product with reference price and differentiated product (at the 3-digit and 4-digit SITC level), Rauch (1999) find that effect of proximity, language and colonial tie on bilateral trade flow are larger for differentiated product.in view of thi, the following quetion i poed: are the previou reult for the extenive margin mainly driven by differentiated product? 12 Export product were claified into (i) product with reference price and (ii) differentiated product, uing the claification developed by Rauch (1999) 13. Thi claification i 10 That the intenive margin decreae with GP per capita i a peculiar finding. A will be evident from the ubequent robutne tet, however, the negative and ignificant parameter etimate for GP per capita i not robut. 11 I ued iteratively re-weighted leat quare in which outlier receive lower weight. The reult are available upon requet. 12 Thi i a tet of the generality of the reult in Table 3. Although the ordering of detination countrie in term of fixed entry cot hould be unaffected by product claification, the magnitude of the effect on each margin may be altered. 13 See the original ource, Rauch (1999), for detail on thi claification. The third type of commoditie, i.e. commoditie traded on organized exchange, were excluded a there were too few countrie that imported uch good from Sweden during the period of analyi to make comparion with the other type of good and the aggregate flow meaningful. A reported in Rauch (1999), commoditie traded on organized exchange accounted for only % of worldwide trade flow in I ued Rauch (1999) claification provided on Jon Haveman indutry trade data webpage (acceed in the pring 2006) ( 14

15 tandard and ha been applied in other tudie, uch a Huang (2006). ue to ambiguitie in the claification, Rauch (1999) ued two alternative claification, a conervative and a liberal. The former minimized the number of 3-digit and 4-digit product that are claified a either organized exchange or reference priced wherea the latter maximized thoe number. Table 5 and 6 preent the parameter etimate of the explanatory variable in (5) for the extenive and intenive margin, repectively, for each type of product. Table 5. Etimated parameter for the extenive margin: commodity claification according to Rauch (1999), (i) differentiated product and (ii) product with reference price. a,b,c,d Conervative claification ifferentiated product Product with reference price ifferentiated product Liberal claification Product with reference price lny 0.54* (12.87) 0.51* (11.62) 0.53* (12.82) 0.53* (12.66) lny cap 0.33* (4.64) 0.36* (4.93) 0.33* (4.61) 0.43* (6.02) d * (-4.21) * (-3.40) * (-4.14) * (-3.47) Nordic 2.33* (5.51) 2.33* (5.73) 2.34* (5.51) 2.32* (5.92) Baltic 2.41* (5.86) 2.37* (5.97) 2.42* (5.86) 2.34* (6.12) Englih 0.48* (3.02) n. 0.49* (3.02) n. AN, 1.02** (1.72) n. 1.02* (-3.55) n. Locked -0.51* (-3.01) -0.39* (-2.14) -0.50* (-2.98) n. I -1.03* (-3.57) -0.67** (-1.76) -1.02* (-3.55) (-2.22) Adj. BP (var(c) =0) * * * * BSY (AR1) 40.83* 33.20* 41.32* 32.70* Etimated auto.corr ( ˆρ ) R # ob a) Etimate obtained from a panel data etimation of Swedih export to 150 detination countrie Random effect etimator adjuted for erially correlated idioyncratic error. b) * indicate ignificance at the 0.05 level, ** indicate ignificance at the 0.10 level. t-value preented within bracket. Inignifcant (level > 0.10) parameter etimate are denoted by n.. c) Adj. BP refer to the tet tatitic of an adjuted Breuch & Pagan (1980) lagrange multiplier (LM) tet for random effect, which work under erially correlated idioyncratic error; H0: ( ) 2 var c = σ =0, ee (7) in the main text. d) BSY refer to the tet tatitic of Bera et al (2001) robut LM-tet for erial correlation in the idioyncratic error, which work in the preence of random effect; H0: E ( ut,, ut, 1 ) =0, ee (7) in the main text. 15

16 Table 6. Etimated parameter for the intenive margin (volume): commodity claification according to Rauch (1999), (i) differentiated product and (ii) product with reference price. a,b,c,d Conervative claification Liberal claification ifferentiated product Product with reference price ifferentiated product Product with reference price lny 0.35* (6.42) 0.58* (8.87) 0.34* (6.26) 0.57* (8.91) ln Y cap n. n. n. n. d * (-5.86) ** (1.92) * (-5.90) * (-1.93) Nordic n. n. n. n. Baltic n. n. n. n. Englih n. n. n. n. AN, 1.06** (1.87) n. 1.48** (1.88) n. Locked -0.66* (-3.06) -0.80* (-2.94) -0.68* (-3.09) -0.66* (-2.34) I n. n. n. n. Adj. BP (var(c) =0) * * * * BSY (AR1) 48.42* 58.52* 50.20* 62.53* Etimated auto.corr ( ˆρ ) R # ob a) Etimate obtained from a panel data etimation of Swedih export to 150 detination countrie Random effect etimator adjuted for erially correlated idioyncratic error. b) * indicate ignificance at the 0.05 level, ** indicate ignificance at the 0.10 level. t-value preented within bracket. Inignifcant (level > 0.10) parameter etimate are denoted by n.. c) Adj. BP refer to the tet tatitic of an adjuted Breuch & Pagan (1980) lagrange multiplier (LM) tet for random effect, which work under erially correlated idioyncratic error; H0: ( ) 2 var c = σ =0, ee (7) in the main text. d) BSY refer to the tet tatitic of Bera et al (2001) robut LM-tet for erial correlation in the idioyncratic error, which work in the preence of random effect; H0: E ( ut,, ut, 1) =0, ee (7) in the main text. There were 150 detination countrie for Swedih export of differentiated product , but 128 and 131 detination for Swedih export of product with reference price with the conervative and liberal claification, repectively. The parameter are etimated uing a random effect etimator adjuted for erial correlation in the idioyncratic error. A in Table 4, the adjuted Breuch & Pagan (1980) lagrange-multiplier (LM) tet how that the null hypothei of no random effect (i.e. countrypecific random error) can be rejected for each model and Bera et al (2001) robut LM tet for erial correlation in the idioyncratic error how that the null hypothei of no erial correlation can be rejected. Moreover, each table alo report the etimated autocorrelation coefficient aociated with each model. 16

17 The reult for the extenive margin Table 5 how that the parameter etimate for the dummy variable aociated with countrie that have Englih a an official language and Autralia and New Zealand, repectively, are only ignificant and poitive for differentiated product. Thi i conitent with the hypothei that trade with differentiated product i more dependent on familiarity than product with reference price. However, the etimated parameter for the dummie for Nordic and Baltic (incl. Poland) countrie, repectively, are ignificant and poitive for both differentiated product and product with reference price. Table 6 reveal that the difference in the parameter etimate between the extenive and the intenive margin reported in Table 4 remain for both differentiated product and product with reference price. The etimated parameter for both, and Englih are inignificant for the intenive margin. However, the dummy for Autralia and New Zealand ha a poitive and ignificant parameter etimate for differentiated product. It i alo evident that the parameter etimate for GP per capita i inignificant for both type of product. Moreover, in Table 6 the etimated parameter for ditance i ignificantly lower for product with reference price than for differentiated product. Thi i in line with previou finding on aggregate bilateral export flow, uch a Rauch (1999) and Huang (2006). Thi difference in parameter etimate, however, i not apparent for the extenive margin in Table CONCLUSIONS Although fixed entry cot play an important role in explanation of the oberved heterogeneity among exporter in term of the extent of their export activitie, the exiting literature ha paid little attention to explanation of the nature and variation of uch cot acro different market, neither in empirical nor theoretical tudie. Thi paper propoed that fixed entry cot are related to familiarity. It wa further maintained that uch a relationhip doe not only help to clarify the nature and variation of fixed entry cot; it alo ugget a precie mechanim through which familiarity affect trade. If higher familiarity tranlate into to lower fixed entry cot, the trade-augmenting effect of familiarity on aggregate trade flow hould primarily repreent adjutment on the extenive margin (number of exporter). The fixed entry cot enter in the deciion of whether to export or not to a given market, but not in the deciion of how much to export ince the fixed entry cot i already paid. Notwithtanding the welldocumented effect of familiarity on trade, hitherto the mechanim by which familiarity enhance export ha to a large extent remained unreolved. Uing a one-ided gravity equation augmented with dummie for familiarity etimated on a panel decribing Swedih unilateral export to 150 detination countrie over even year it wa hown that the effect of familiarity on the volume of aggregate export i excluively due to adjutment on the extenive margin. The reult are thu conitent with the hypothei that familiarity primarily i aociated with the ize of fixed (unk) entry cot. The magnitude of the effect of familiarity on aggregate export flow how that adjutment on the extenive margin are large and economic ignificant. In addition, the model wa hown to better predict the extenive margin than the intenive margin. For aggregate export, the fit of the model for the former margin were more than three time a large a for the latter. Uing the commodity claification in Rauch (1999), it wa further hown the effect of familiarity on the extenive margin hold for both product with reference price and differentiated product. Language familiarity, though, had only a ignificant effect on the extenive margin for differentiated product. The finding in the paper upport general equilibrium model that owe to the export deciion of individual firm and incorporate firm heterogeneity, uch a Chaney (2006) and Eaton et al (2005). The reult alo hed light on the nature and variation of fixed (unk) entry cot acro market. In doing o, they partly elucidate the mytery of the miing trade (Trefler 1995). Anderon (2000) maintain that there mut be extra tranaction cot on top of ditance. A familiarity ha a geographical component thee extra cot can (at leat partly) be attributed to fixed unk cot of entry, which give Nordic Baltic 17