TRADE EFFECTS OF REGIONAL STANDARDS LIBERALIZATION A HETEROGENEOUS FIRMS APPROACH. Silja Baller* World Bank

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized TRADE EFFECTS OF REGIONAL STANDARDS LIBERALIZATION A HETEROGENEOUS FIRMS APPROACH Sil Bller* World Bnk Abstrct This study investigtes trde effects of the regionl liberliztion of technicl brriers to trde (TBTs) in the form of hrmoniztion nd mutul recognition greements (MRAs) for testing procedures. The theoreticl prt of the pper is frmed in terms of heterogeneous firms pproch. This pper dds to the existing literture by formlizing the effects of MRAs nd hrmoniztion inititives on bilterl trde flows nd by pplying this new theoreticl frmework in the empiricl prt of the pper. The ltter consists of two-stge grvity estimtion nd investigtes sectorl effects of regionl TBT liberliztion on prties to the greement s well s excluded industrilized nd developing countries. It finds tht MRAs hve strong positive influence on both export probbilities nd trde volumes for prtner countries. Regrding hrmoniztion, results seem to suggest tht the impct on prties to the greement is negligible, however tht on excluded OECD countries is lrge nd positive. Third prty developing countries do not seem to benefit from the mrket integrtion effect brought bout by hrmoniztion in other regions. Overll, effects on the probbility tht new firm will export re much more pronounced thn effects on the trde volumes of incumbent exporters. World Bnk Policy Reserch Working Pper 424, Februry 2007 WPS424 The Policy Reserch Working Pper Series dissemintes the findings of work in progress to encourge the exchnge of ides bout development issues. An obective of the series is to get the findings out quickly, even if the presenttions re less thn fully polished. The ppers crry the nmes of the uthors nd should be cited ccordingly. The findings, interprettions, nd conclusions expressed in this pper re entirely those of the uthors. They do not necessrily represent the view of the World Bnk, its Executive Directors, or the countries they represent. Policy Reserch Working Ppers re vilble online t Acknowledgements The uthor hs benefited from the guidnce of nd helpful discussions with Richrd Bldwin nd Mon Hddd s well s vluble comments from Pul Brenton, John Cuddy, Brbr Fliess, Sudrshn Gooptu, Mrion Jnsen, Ptrick Low, Mrc Melitz, Robert Piermrtini, Benmin Shepherd nd John Wilson. * Correspondence: sbller@worldbnk.org, Est Asi nd Pcific Region, Poverty Reduction nd Economic Mngement Sector

2 Tble of Contents Introduction...3 SECTION I...5 Txonomy of Stndrds...5 Stndrds s Trde Brriers...7 Overcoming TBTs...8 SECTION II... Literture... SECTION III...2 Melitz model nd extensions...2 SECTION IV...7 Empirics...7 SECTION V...22 Dt...22 Implementtion...22 SECTION VI...24 Results...24 Stge...24 Stge SECTION VII...25 Policy Implictions...25 Conclusion...26 Appendix I Derivtion of S...28 Appendix II Derivtion of the empiricl specifiction following HMR...3 Appendix III Countries included in the smple...33 Appendix IV Mutul Recognition Agreements...34 Appendix V - Hrmoniztion...36 Appendix VI Regression results...37 VI. Stge - Country-Pir Fixed Effects...37 VI.2 Stge Exporter-, Importer- nd Yer-Fixed Effects...38 VI.3 Stge 2 Exporter-, Importer, nd Yer-Fixed Effects OLS Corrected for Heckmn Selection Bis nd Heterogeneity Bis vi yht...39 Bibliogrphy 40 2

3 Introduction As the 20 th century drew to close, GATT s originl gol of grdul bolishment of triffs nd quots hd been chieved to considerble extent. Yet, s Robert Bldwin points out s erly s 970, this leves the plying field still fr from level: The lowering of triffs hs, in effect, been like drining swmp. The lower wter level hs reveled ll the sngs nd stumps of non-triff brriers tht still hve to be clered wy. With triff brriers becoming incresingly less importnt, differences in ntionl regultory regimes re becoming ever more visible. These regultory regimes include res s vried s government procurement rules, inwrd foreign investment, competition policy, lbor stndrds nd environmentl norms s well s product stndrds nd technicl regultions (Hoekmn, Mttoo, English, 2002). This pper hs singled out technicl regultions (termed technicl brriers to trde or TBTs in the WTO context) s one prticulr domestic regultory regime nd will nlyze the mens tht hve been employed in recent yers to overcome the negtive trde-effects thereof. Firm-level surveys conducted in both industril nd developing countries, consistently identify technicl regultions (long with rules of origin nd customs procedures) s the min non-triff export constrint (World Bnk TBT Survey, 2004; OECD metsurvey 2003). Richrd Bldwin (2000) points out tht TBTs hve been the min concern of the EU s fr s trde brriers re concerned ever since the bolishment of ll internl triffs in 973. In the context of the recently lunched trde tlks between the EU nd ASEAN, Pscl Lmy expressed the belief tht hrmonizing stndrds nd rules in res such s sfety, helth or consumer protection rther thn bolishing triffs nd quots, were the rel 2 st century trde issues. The urgency of the topic is further underlined by the significnt rise in WTO dispute settlement cse lod tht turns on stndrds-relted issues. This study will investigte trde effects of TBT liberliztion in the form of hrmoniztion nd mutul recognition greements for testing procedures (MRAs). The theoreticl prt of the pper is frmed in terms of Melitz s (2003) heterogeneous firms pproch. The pper develops Melitz s model so s to formlize the effects of MRAs nd hrmoniztion inititives on bilterl trde flows nd pplies this new theoreticl frmework in the empiricl prt of the pper. The ltter consists of twostge grvity estimtion nd investigtes sectorl effects of TBT liberliztion on prties to the greement s well s excluded industrilized nd developing countries respectively. In Section I, technicl issues surrounding stndrds s well s liberliztion efforts in this re will be discussed. Different types of stndrds will be defined nd clssified. The pper will subsequently focus only on government imposed technicl regultions. The vrious ctegories of legl instruments tht hve been employed to overcome trde-distorting effects connected to them will be discussed. The nlysis will then focus on hrmoniztion inititives nd mutul recognition greements (MRAs) of testing procedures s two such instruments. quoted in Chen nd Mttoo (2004) 3

4 Section II provides brief overview of the existing theoreticl nd empiricl literture on the topic, which is currently not very extensive. Most empiricl ppers on the subect lck sound theoreticl underpinnings, wekness tht this pper ttempts to overcome. Sections III nd IV discuss the theoreticl model nd empiricl derivtion upon which the nlysis will be bsed. Within these sections, the existing theory is developed so s to formlize issues rising from TBT liberliztion. In Melitz (2003), the decision of firm to enter into n export mrket hinges crucilly on the level of fixed cost in given mrket. It is here, tht technicl brriers to trde s n importnt type of fixed export cost re introduced into the model. TBT liberliztion cn then tke the form of MRAs modelled in this pper s reduction in fixed export cost or complete hrmoniztion modelled here s n elimintion of fixed costs for ll but the home mrket, such tht firm is now mking oint entry decision for ll mrkets in the hrmonizing region. Despite the fct tht formlly modelling effects of such preferentil liberliztion greements on excluded countries is beyond the scope of this pper, this spect is included in the empiricl prt. Crucilly, in prticulr for the empiricl nlysis, Melitz points to two mrgins of dustment for trde flows rising from the endogenous firm selection process: the volume of trde flows will be determined by the volume of exports by ech individul exporting firm (the intensive mrgin) s well s the frction of firms ctully exporting (the extensive mrgin). This theoreticl bckground gives rise to twostge estimtion structure, where the first stge consists of probit grvity eqution yielding proxy for the extensive mrgin. The ltter is then used to correct for heterogeneity bis in the second stge of the estimtion, which is n otherwise stndrd grvity eqution (in effect Tobit II model with correction for firm heterogeneity). Implementtion issues re discussed in Section V. The nlysis is conducted t the sectorl level, focusing on the telecoms nd medicl device industries. It is found tht MRAs hve strong positive influence on both export probbilities nd trde volumes for prtner countries. Regrding hrmoniztion, results seem to suggest tht the impct on prties to the greement is negligible, however tht on excluded OECD countries is lrge nd positive. Excluded developing countries generlly do not seem to benefit from the mrket integrtion effect brought bout by hrmoniztion in other regions. Overll, effects on the probbility tht new firm will export re much more pronounced thn effects on the trde volumes of incumbent exporters. Results re robust cross different time periods nd sectors. All results re discussed in detil in Section VI. 4

5 SECTION I Txonomy of Stndrds Technicl brriers to trde cn be seen s resulting from stndrds tht specify either product chrcteristics or process nd production methods. Bldwin (2000) distinguishes between two spects of these stndrds (both of which crete brrier): i) content of the stndrd nd ii) testing procedures necessry to demonstrte tht product complies with given stndrd. The WTO defines stndrd s follows: ( ) stndrds set out specific chrcteristics of product such s its size, shpe, design, functions nd performnce, or the wy it is lbeled or pckged before it is put on sle. In certin cses, the wy product is produced cn ffect these chrcteristics, nd it my then prove more pproprite to drft ( ) stndrds in terms of product's process nd production methods rther thn its chrcteristics per se. ( ) Given this definition, this section describes the three situtions where stndrds re necessry. These re () where comptibility ) of inputs or b) mong finl products needs to be ssured; (2) where there is symmetric informtion between producers nd consumers bout product qulity; nd (3) in situtions where goods re produced or consumed under negtive externlities. Cse is generlly tken cre of by the mrket. Since cses 2 nd 3 re situtions of mrket filure, however, government intervention will be necessry. Cse : Stndrds re often needed to ensure comptibility between product prts. In cses where firms re verticlly integrted, these stndrds re generlly proprietry to the individul firm. However, the logic of splitting the production process verticlly nd creting competition between the suppliers of inputs would require these stndrds to be mde public. Incresed stndrdiztion of inputs will benefit the firms which ssemble the finl products s it serves to thicken supplier mrkets nd thereby depresses prices of inputs. This decrese in mrgin will hurt incumbents in the input mrket, yet t the sme time, the reduction in entry brriers tht is cused by the fct tht technology for inputs is no longer proprietry opens the wy for new entrnts. Cse b: Comptibility between finl products is prticulrly crucil for ny kind of network product (such s fx mchines or computer softwre). When new network product is brought to the mrket, every firm will wnt to impose their stndrd on the entire mrket, so s to hve n initil dvntge in terms of production cost. The new common stndrd cn rise either through stndrds wr or mutul greement between firms in the industry (cf. product cycle literture, e.g. Utterbch nd Surez s (993) notion of dominnt design ). Government should not intervene in this process unless the stndrd tht is imposed on the mrket is proprietry to n individul firm (becuse technology is proprietry), which would in certin cses hve to rise nti-competitive concerns. 5

6 It should be noted tht in both of the bove cses, stndrds re needed for efficiency resons. Bldwin (2000) clls these horizontl stndrds. Unless there is dnger of sub-optiml convergence or convergence inerti, the mrket cn be expected to generte optiml common stndrds nd government intervention is hence unwrrnted. Further, cses 2 nd 3 describe situtions where stndrds re required in order to correct for mrket filure. Rther thn being ust technicl specifictions, these re minimum qulity stndrds to gurntee the helth nd sfety of the consumer or the protection of the environment Bldwin (2000) clls these verticl stndrds. Pelkmns (2003) refers to them s SHEC stndrds (Sfety, Helth, Environment nd Consumer Protection). These re the types of stndrds tht tend to get the lrgest public ttention, s they re TBTs tht cn esily be portryed s protecting locl consumers from low-qulity imports. Cse 2 is concerned with symmetric informtion bout product qulity the cse of experience nd credence goods. An experience good is defined s good, the qulity of which cn be scertined only fter consumption. In the cse of credence good, on the other hnd, certin product chrcteristics my never be reveled to the consumer even fter consumption. The mrket filure in this cse is symmetric informtion bout the true chrcteristics of the product, including helth nd sfety fetures. An exmple for n experience good would be motorcycle helmet, the true qulity of which would only be reveled during n ccident. Since the consumer hs no possibility of verifying the qulity of the product ex nte, government will hve to step in nd impose minimum stndrds tht gurntee the helth nd sfety of the consumer. An exmple for credence good would be bottled wter, the true qulity of which consumer will never be ble to estblish. Agin, government intervention is necessry. Finlly, cse 3 dels with goods tht re produced or consumed under negtive externlities, mening tht there re negtive side effects on third prties from the consumption nd production of goods which re ignored in the consumption/production decision. Under the ssumption of complete informtion, the most efficient outcome would be reched by imposing n pproprite tx. However, in second best world, where informtion is incomplete, setting minimum/mximum stndrd might be the optiml solution to solving the externlity problem. Often cited exmples re mximum levels of led in petrol or of pesticide residues on griculturl goods. One cn conclude from the bove, tht stndrds no mtter whether privte or public re in ll three cses necessry. Both symmetric informtion nd negtive externlities re mrket filures nd hence require government intervention, here in the form of minimum qulity stndrds. These my vry by country depending on the ttitude towrds risk in given society. 6

7 Stndrds s Trde Brriers Despite the fct tht stndrds re importnt in chieving efficiency, their presence cn turn out to be n obstcle to trde: while integrting the mrkets of those who prticipte, stndrds cn ct s brrier to those who re excluded. In the cse of comptibility stndrds, mrket forces will ct to bring stndrds in line with those generlly previling in the mrket, even though these stndrds re techniclly voluntry. Products not meeting these stndrds my simply not be demnded by firms/consumers s they re incomptible with the other inputs (s in Cse ) or the previling network (s in Cse b). In the cse of government imposed qulity stndrds, on the other hnd, complince is mndtory. In this cse the stndrds re lso known s technicl regultions. Products not meeting these technicl regultions will be bnned from the mrket. Country-specific stndrds effectively crete dditionl costs for foreign producers by forcing them to dust their product nd production process so s to meet individul ntionl stndrds. Further costs will rise from the requirement to subsequently prove conformity with these stndrds (World Bnk TBT Survey, 2004; Bldwin, 2000; Chen nd Mttoo, 2004; Wilson, Chen nd Otsuki, 2006). This cretes two negtive side effects: Firstly, foreign producers re hurt by incresed (possibly prohibitive) production costs. This my turn out to be prticulrly burdensome for developing countries trying to get ccess to industrilized countries mrkets. 2 Second, by creting rtificil entry brriers to ntionl mrkets, stndrds hve negtive effect on efficiency. This is due to the fct tht firms which re forced to meet different stndrds for different mrkets re unble to tke dvntge of economies of scle, thereby dmpening productive efficiency. As mrkets remin segmented by stndrds brriers, firms re further ble to rise price over mrginl cost, implying less lloctive efficiency thn could be reched with integrted mrkets. Even though stndrds re vluble in nd of themselves, these effects hve to be tken into ccount when setting them. Additionlly, Bldwin (2000) points to mgnifiction effect of globliztion : the greter the freeness of trde, the greter the effect of ny remining brriers especilly from n economic geogrphy point of view. In other words, reduction in distortion rising from triff brriers, will led to n incresed impct of regultory differences on the loction of production. Finlly, such regultions cn esily be bused by protectionists to crete rtificil entry brriers to the domestic mrket. It is generlly difficult to tell, which purpose prticulr stndrd or regultion serves, but there is likely to be n element of both motivtions in either. This inherent mbiguity mkes it difficult to overcome stndrds nd regultions s technicl brriers to trde (TBTs) entirely, but two second-best mesures in prticulr hrmoniztion nd mutul recognition of testing procedures will be the subect of this pper. The pper will focus on liberliztion/hrmoniztion of government-imposed regultions rther thn voluntry industry stndrds. 2 cf. World Bnk Survey on TBTs: Wilson nd Otsuki (2004) Stndrds nd Technicl Regultions nd Firms in Developing Countries: New evidence from World Bnk Technicl Brriers to Trde Survey ; find tht stndrds nd technicl regultions re n importnt fctor ffecting firm s opertion nd bility to export. 7

8 But, yet gin, cre must be tken tht liberliztion of these brriers does not hppen in wy tht results in disdvntge for the wekest. The wy technicl brriers to trde re being tckled t the moment, i.e. minly through greements between industrilized countries, might men even more trde diversion wy from developing third country producers. Overcoming TBTs Even though stndrds hve been shown to constitute brrier to trde, they re vluble in nd of themselves s rgued bove. Since removing the stndrds themselves is therefore not n option, the level plying field will hve to be creted by ccepting their presence nd mking them comptible. Disciplines imposed by the WTO in this regrd re reltively lx due to the fct tht the optiml level of helth or sfety stndrds depends to lrge extent on the level of development of the individul country, so tht it is currently impossible to impose common stndrds for ll WTO members. Some provisions in this regrd re, however, contined in the Agreements on Technicl Brriers to Trde (TBT). 3 The Premble to the WTO TBT Agreement sttes tht no country should be prevented from tking mesures necessry to ensure the qulity of its exports, or for the protection of humn, niml, nd plnt life or helth, of the environment, or for the prevention of deceptive prctices, t the levels it considers pproprite. However, the regultory flexibility of WTO members is limited by the requirement tht technicl regultions re not prepred, dopted or pplied with view to, or with the effect of, creting unnecessry obstcles to trde. (Article 2.2) In ddition, the TBT Agreement sets some bsic guidelines in terms of trnsprency, proportionlity ( blncing requirement, i.e. the mesure implemented should be proportionl to the desired obective), necessity, nd consistency. 4 These provisions re necessry to prevent governments from hiding protectionist intentions behind SHEC rguments. Even though mny of these government imposed stndrds my be ustifible, the WTO DSB hs found in severl instnces tht mesures were unnecessrily trde distorting (possibly expressly). 5 The disciplines imposed by the TBT Agreement re mostly concerned with government imposed stndrds, though the Agreements lso suggest best prctice guidelines for the process of stndrd setting nd removl of stndrds brriers (such s hrmoniztion) both for industry nd for government. It should be noted tht these re expressly non-binding. 3 Similr provisions cn be found in the Agreement on Snitry nd Phytosnitry (SPS) mesures, which is concerned with stndrds imed t preventing the spred of pests nd diseses nd ensuring food sfety. SPS-relted stndrds re, however, not subect of this pper. 4 The implictions of these conditions re elborted in vrious WTO DSB Cses: blncing : Kore Vrious Mesures on Beef; necessity requirement: EC Asbestos; consistency: EC Hormones; process nd production methods: US Import Prohibition of Certin Shrimp nd Shrimp Products. 5 Cf. lso Derdorff nd Stern (997) on the difficulty of disentngling legitimte mesures from protectionist ones. 8

9 As rgued bove, in the cse of comptibility of network goods/inputs, stndrd setting is generlly privte sector driven, giving rise to voluntry stndrds regimes tht minly convey informtion s to wht is ccepted/expected by the mrket. Hrmoniztion is enforced by the mrket mechnism: incomptible products re driven out, unless new stndrd is so strong s to cpture criticl mss of the mrket. It is worth noting tht mrkets, in this cse, cnnot be ssumed to be confined to ntionl borders. Where industries re globl, the mrket will crete interntionl stndrds. Privte sector orgniztions such s ISO nd IEC hve been instrumentl in driving this process nd hve creted lrge number of voluntry interntionl stndrds over the lst decdes. In the cse of mndtory sfety/helth nd environmentl stndrds, government ction is required for the removl of stndrd-relted brriers. In ddition, complince with interntionlly greed mndtory stndrds will subsequently hve to be monitored on continuous bsis (this is done through conformity ssessment procedures) nd enforced by the individul governments. Since WTO disciplines in this regrd re of reltively little stringency (s shown bove), more mbitious pproches hve been developed in the context of vrious regionl trding rrngements, where it cn be ssumed tht socil preferences nd constrints re more similr. These inititives cn be grouped s follows: Mutul recognition of product stndrds nd technicl regultions (if extended unilterlly, referred to s "equivlence" nd not to be confused with Mutul Recognition Agreements for conformity ssessment procedures): under mutul recognition it is presumed tht stndrds, though vrying per se, re designed to meet the sme regultory obectives nd there is hence no need for further greement. This prctice is very common within the Europen Union nd covers pproximtely 28% of ll products in the EU. Hrmoniztion by essentil chrcteristics (the EU's "new pproch"): consists of defining essentil sfety requirements to be fulfilled by product, but leving the producer free to design the rest of the product s they see fit. These essentil requirements often give rise to voluntry product stndrds developed by industry, implying tht product which complies with these voluntry stndrds lso fulfils the essentil requirements. Producers which do not comply with these stndrds hve to prove in different wy tht they comply with the regultion. This method ws originlly pioneered by the EU nd hs since then been dopted by AFTA nd APEC. Hrmoniztion product-by-product (EU's "old pproch"): this pproch ws used by the EU until 985 nd involved tedious product-by-product legisltion implemented through numerous detiled directives. Becuse the high techniclity of the process thretened the gol of completing the Single Mrket by 992, it ws decided to bndon the product-by-product pproch in fvour of the essentil chrcteristics pproch. Comptibility (s used in NAFTA): there does not seem to be forml definition of this concept in ny of the relevnt legl texts, yet it seems to imply hrmoniztion of ll regultions tht re being newly creted. Acceptnce with specific exceptions: country which hs not dopted interntionl stndrds still hs to ccept products from prtners which comply with these stndrds, unless they cn demonstrte n inbility to dopt the 9

10 interntionl stndrd due to "climtic conditions or infrstructurl resons" (e.g. AFTA). Acceptnce with brod exceptions (e.g. WTO) It should lso be noted tht the mesures listed bove re by no mens mutully exclusive, but rther often exist longside ech other. It is for exmple the cse for the EU tht only 5% of regulted products re subect to hrmoniztion directives, while the other prt of regulted products re subect to the mutul recognition principle (The Single Mrket Review, EC 998). Mutul recognition of stndrds is currently only pplied by the EU, s it requires strong enforcement mechnism ( role tht is plyed by Europen Court of Justice). Hrmoniztion of stndrds, on the other hnd hs been greed upon in number of recent preferentil greements, especilly those with the EU s one of the prtners s well s within AFTA nd APEC. In the cse of EU greements, prtners re generlly sked to hrmonize to EU stndrds (with the exception of EU-Chile nd EU-Mexico, which hrmonize to interntionl stndrds), wheres AFTA nd APEC sk members to hrmonize to interntionl stndrds. NAFTA members hve greed to mke their stndrds comptible, which cn be interpreted s hrmoniztion, but the principle is only pplied to stndrds tht re being newly creted. Besides these rrngements, which im to overcome brriers posed by stndrds nd technicl regultions directly, rrngements concerning conformity ssessment procedures (i.e. lbortory testing to see whether product complies with given stndrd or regultion) nd mutul recognition thereof hve been gining incresing importnce. These types of greement re less intrusive thn direct hrmoniztion in tht they do not require countries to chnge domestic regultions. MRAs for testing procedures re greements between two or more prties to mutully recognize or ccept some or ll spects of one nother s conformity ssessment results (e.g. test reports nd certifictes of complince), thereby voiding the costs of double testing. 6 Through MRAs, products tht re tested nd certified before export cn enter the importing country directly without hving to undergo similr conformity ssessment procedures in the importing country. As opposed to Mutul Recognition of the ctul product stndrds or hrmoniztion thereof, MRAs for testing procedures do not require two trding prtners to hve comprble SHEC stndrds per se they only require the exporter to fulfill the stndrds of the prtner for the product they wish to export, but not meet the sme regultory obectives for their own country. In this sense, MRAs cn be seen s first step towrds stndrds integrtion nd they hve indeed become n importnt tool for trde fcilittion. Testing MRAs cn come in two guises: technicl nd government-to-government (Gto-G). Technicl MRAs re concluded between technicl bodies (testing lbortories, inspection bodies, certifiction bodies, ccredittion bodies) nd while they re nonbinding nd therefore not enforceble, they often build the foundtion for greements t the government level. The ltter re generlly concluded for specific product sectors under government regultion. Exmples re MRAs concluded between the EU nd third countries (USA, Cnd, Austrli, New Zelnd, Isrel, Jpn, Switzerlnd). APEC s Sub-committee on Stndrds nd Conformnce (SCSC) is in 6 Definition from Report of the Tskforce on Developing Rodmp to Mutul Recognition Agreements in ASEAN; report submitted to th meeting of the ACCSQ -2 Mrch 998 0

11 the process of negotiting them for the Asi Pcific region. MRAs cn be both bilterl nd multi-lterl s well s single- nd multi-sector. While APEC MRAs, for exmple hve been single-sector, the EU hs generlly dopted multi-sector pproch since negotitions of multi-sector frmework re rgubly esier, s rough blnce of gins is more esily obtined. Further, G-to-G MRAs cn be grouped into 3 different types: i) full hrmoniztion of conformity ssessment, ii) equivlence of complince ( unilterl recognition of complince), iii) full recognition of conformity ssessment (conceptully these re similr to rrngements concerning stndrds directly see definitions given in this context bove). An exmple for full hrmoniztion of conformity ssessment regultion would be the EU s Single Mrket frmework. Equivlence of complince is the bsis to the Trns- Tsmn MRA between Austrli nd New Zelnd, while the bulk of G-to-G MRAs relies on the third ctegory of full recognition of conformity ssessment results. The ltter mens prtners re testing nd certifying products ccording to the stndrds nd requirements of the importing country; subsequently, certificte indicting full complince with those requirements is issued by the exporting country nd must be ccepted by the importer. 7-8 The min concern of the subsequent nlysis will be to estimte the impct of regionl TBT liberliztion, in prticulr the effects of two specific types of inititive: Mutul Recognition Agreements on testing procedures s well s hrmoniztion of product stndrds. For ll other pproches the degree of implementtion is difficult to udge in prctice. Legl texts re often vgue to the extent tht they only recommend certin mesures rther thn being binding in this respect. The impct of MRAs on trde will be tested only for members of the greement, while the effects of hrmoniztion will be tested both for members of the liberlizing region s well s excluded countries. SECTION II Literture The reltionship between stndrds nd trde hs only recently strted to receive ttention from reserchers. The min strnds of the stndrds-literture hve so fr been more concerned with the link between stndrds nd innovtion nd stndrds nd growth. 9 Firm level surveys hve been conducted, ttempting to guge the direct impct of stndrds nd technicl regultions on firms production costs nd hence export performnce. The World Bnk TBT survey looks t 689 firms in over 20 industries in 7 developing countries (Wilson nd Otsuki, 2004). 70% of these firms report tht they fce technicl regultions in their export mrkets, whereby EU nd US 7 Bsed on ibid. 8 For full list of MRAs nd Hrmoniztion inititives, plese refer to Appendix IV nd V. 9 For generl overviews of the stndrdistion literture see Frrell nd Sloner (987), Dvid nd Greenstein (990), Ktz nd Shpiro (994) nd Mtutes nd Regibeu (996); the smll prt of the literture tht is concerned with trde issues is represented by Mtutes nd Regibeu (996), Kende (992), Gndl nd Shy (996), Wllner (998), Jenneret nd Verdier (996) nd DIN (Deutsches Institut für Normung, 999); e.g. Blind nd Jungmittg (2004), Jungmittg, Blind nd Grupp (999).

12 regultions re generlly considered the most importnt by the firms surveyed. The study shows tht in order to meet stndrds, firms invest in dditionl plnt or equipment, one-time product redesign, product redesign for ech export mrket, dditionl lbor for production, dditionl lbor for testing nd certifiction, or ly off workers insted of mking these types of investment in order to keep the costs from incresing. Quntittive nlysis deriving the trde effect of diverging stndrds directly from the number or costs of stndrds hs generlly proven chllenging due to the lrge number of stndrds in existence. Additionlly, the welth nd idiosyncrsy of legl documents recording them mkes it difficult to mtch stndrds cross countries. Studies conducted in this vein re those by Moenius, 999; Swnn, Temple nd Shurmer, 996; Vncuteren nd Weiserbs, 2003; Mntovni & Vncuteren, A generl wekness of these ttempts to estimte the impct of stndrds on trde is tht they re generlly not bsed on sound theoreticl frmework. The ttempts of modelling stndrds brriers nd their remedies theoreticlly re lso very limited in number nd hve been undertken only very recently. All of them use Krugmn s (980) frmework s the bsis to model trde between countries, but re very different in the wy they re being implemented. One pper tht hs endevored to formlly model TBTs (yet not their liberliztion) nd showing the need to overcome them is Gnslndt & Mrkusen (200). Bldwin (2000) s well s Mttoo nd Chen (2004) tke the nlysis step further by modelling both TBTs nd their liberliztion, cutioning ginst the discrimintory effects tht the ltter my entil. Mttoo nd Chen (2004) find tht hrmoniztion in the EU rises both intr-regionl trde s well s trde with excluded developed countries; t the sme time their results indicte tht it diverts trde wy from developing countries. The pper lso shows tht MRAs hve more powerful impct on both types of trde, but if they contin rules of origin, then intr-regionl trde increses t the expense of imports from the rest of the world, especilly developing countries. In firm level nlysis Chen, Wilson nd Otsuki (2004) show tht testing procedures nd lengthy inspection reduce exports of developing countries by 9% nd 3% respectively nd stndrds reduce the likelihood of exporting to more thn three mrkets by 7%. SECTION III Melitz model nd extensions Given recent developments in interntionl trde theory, it seems tht dditionl insight into the nture of technicl brriers to trde s well s their liberliztion cn be gined by formulting model in terms of Melitz s (2003) heterogeneous firms frmework. Melitz s model constitutes n improvement over existing trde models to the extent tht it is ble to explin the mny zero entries in the globl trde mtrix (i.e. the fct tht more thn hlf of bilterl country pirs hve no trding reltionship t ll) s well s ppropritely reflecting the symmetry of bilterl trde-flows. Both of these fetures re obtined vi the endogenous selection of individul firms into one or severl export mrkets. Crucilly, Melitz points to two mrgins of dustment for 2

13 trde flows rising from this selection process. The volume of trde flows will be determined by the volume of exports by ech individul exporting firm (the intensive mrgin) s well s the frction of firms ctully exporting (the extensive mrgin). The subsequent section will provide brief introduction to the originl model 0 nd develop n extension to the theory so s to formlize regionl TBT liberliztion inititives. As generl set-up for his model, Melitz (2003) uses the frmework first introduced by Krugmn (980), in tht he ssumes 2-country, 2-good, single fctor-ofproduction setting (the only fctor being lbour). One of the goods is homogeneous nd is produced in the A-sector under Wlrsin conditions. Trde for this good is costless. The other good is produced in Dixit-Stiglitz monopolistic competition setting with incresing returns to scle nd ice-berg trde costs, τ. Consumer preferences re represented by two-tier utility function. The upper tier is Cobb- Dougls nd determines the reltive expenditure shres on A- nd M-sector goods respectively, while the second tier defines preferences over the differentited M- sector vrieties. /( / σ ) μ μ σ U = C M C A ; C, N M ci di 0 < μ < < σ () i= 0 C M represents consumption of the composite of ll differentited vrieties of goods M nd C A is consumption of the homogeneous good A, μ nd -μ re the respective expenditure shres, N is the mss of vrieties nd σ is the constnt elsticity of substitution between ny two mnufctured vrieties. In the M-sector, firms fce 4 types of cost: constnt mrginl cost of production s well s 3 types of fixed cost: F hs to be pid in order to cquire ptent for unique vriety so tht production is possible t ll. Further, mrket entry costs F D nd F X hve to be pid for both the domestic nd the foreign mrket respectively. These elements of the model will be of prticulr relevnce for subsequent nlysis. We will ssume F X > F D, where F X cn be interpreted s fixed costs rising from dpttion to stndrds nd technicl regultions brod. It should be noted tht previous models hve considered TBTs to ffect both fixed nd vrible costs. Since the nlyticl results for vrible cost TBTs re stright-forwrd nd the lrger prt of the costs is hypothesized to come from fixed costs, I will ultimtely focus on the effects of chnges in fixed costs following regionl liberliztion. Vrible costs in the domestic nd foreign mrket cn be expressed s follows: c i i w nd c i * i τ w (2) where c i re sles in mrket i, i is the unit input coefficient (or the firm s level of inefficiency), w is the wge nd τ the ice-berg trde-cost. The model deprts from stndrd new trde theory in tht it ssumes M-sector firms to be heterogeneous in their productivity levels i. In Melitz s model, ech firm drws their own i from Preto distribution (this prt of the model is crucil nd will be developed further below). 0 Bsed on Bldwin nd Robert-Nicoud (2004) The concept of iceberg trde costs is due to Smuelson (954), who modeled trnsport costs s using up prt of the good tht is being trnsported. It is very convenient wy of modeling trde costs s it ffects no other mrket. 3

14 The short-run equilibrium where the number nd types of firms re fixed is chrcterized s follows: A-sector results re stndrd nd stright-forwrd; ultimtely, the conditions found in the A-sector ensure tht fctor-prices re equlized t w = w* =. In the M-sector, we will, crucilly, see the following: two cut-off levels of i will determine which firms will be producing t ll, which will produce only for the domestic mrket nd which will be ble lso to export, the intuition being tht only sufficiently high level of productivity (i.e. low mrginl cost nd therefore low price) will generte enough sles so s to cover fixed entry costs for the domestic or domestic s well s foreign mrket. The cut-off level for exporting firms will be clled X. Any firm with unit input coefficient below X will be efficient enough to be ble to export. As in the stndrd Dixit-Stiglitz model, prices of M-sector firms will be constnt mrk-up over mrginl cost, i nd i τ respectively. Prices for the domestic nd the export mrket re therefore given by: = i τ p nd p * = i (3) σ σ In the short-run, the mss of ctive firms is tken s fixed t n nd the distribution of - the i s is lso given. The productivity distribution cn be expressed s the pdf ρ D ρ ρ-. Operting profits in Dixit-Stiglitz re simply /σ multiplied by firm-level sles; we cn hence write operting profits in the domestic mrket s π D E = B (4) nσ where E is mrket-specific expenditure on ll vrieties nd n is the mss of ctive firms. B is introduced to simplify nottion nd cptures bises in mrket shres of individul firms determined by their productivities : the verge operting profit erned by firms is E/nσ, but firm s operting profits will be bised depending on firm s productivity reltive to the verge productivity. If written out in its entirety, σ B = (5) D X σ σ g d + g d [ ] [ ] 0 0 The expression in the denomintor will lter be clled Δ for simplicity. For the export mrket, operting profits cn be written s π X E i = φb (6) nσ Totl expenditure in given sector is E = μl, where μ is the shre of income spent on M-sector goods nd L is totl lbour income, which is the only source of income, since in equilibrium there re no pure profits. As firms hve to mke fixed cost investments, short-run profits re ust sufficient to cover these outlys. In the Melitz model, the long-run equilibrium is defined s sitution where no pure profits re erned. This condition will pin down the totl number of ctive firms in the M-sector s well s the two productivity cut-off conditions D nd X. Since M-sector firms re heterogeneous in the Melitz model, there seems to be the need to model this heterogeneity explicitly. Melitz does so by ssuming tht every firm wnting to produce new vriety spends fixed cost F on ptent, not knowing in dvnce wht the productivity level inherent in this ptent will be. This is modeled by mking the firm rndomly drw i from Preto distribution, G[]=(/ 0 ) γ, γ being the shpe prmeter of the distribution nd 0 the highest possible unit input 4

15 coefficient. 2 Depending on the level relized, the firm will be ble to export, solely supply the domestic mrket or not produce t ll. We cn implicitly define the cut-off points for vi the free entry condition: for the domestic mrket (from the condition tht operting profits equl fixed costs for the lest profitble exporter): σ D E < D ; = FD (7) Δ nσ Similrly, for the export mrket: σ φ X E < X ; = FX where F X > F D (7b) Δ nσ From this, we cn derive the vlue of n individul ptent, which will be equl to operting profits minus mrket entry costs. The zero-profit condition in the innovtion process on verge will determine the equilibrium number of firms in the mrket. As the number of ptents sold (which is equivlent to the number of firms in the mrket) rises, profits re grdully driven to zero. Ultimtely, the long-run number nd distribution of firms will be determined by n, D nd X, which in turn rise from the simultneous solution of the cut-off conditions nd the innovtion sector s zero-profit condition yielding n equilibrium number of firms of σ + ρ L / FD μ F σ X n = where 0 < Γ = < + φγ σλ φf D The productivity cut-offs D nd X cn be written s follows: ρ I / FD D = 0 (9) ( 2λ )( + φγ) σ σ + ρ ( F ) σ ( ) ( σ )( ) ρ X FD I ρ ( 2λ ) ρ ( + φγ) ρ 0φ = (9b) X (8) Where I is the cut-off vlue for profitbility of the I-sector, which produces the ptents. In wht follows, the pper develops Melitz s model further to formlize TBT liberliztion in the form of mutul recognition greements nd hrmoniztion respectively. It could be rgued tht mutul recognition greements of conformity ssessment procedures will led to less of drop in fixed costs ssocited with TBTs thn hrmoniztion. We could therefore model regime chnge s fr s MRAs for testing re concerned simply s drop in F X implying less stringent conditions for exporters X will rise, while D will drop due to incresed competition from brod. 2 the use of the Preto distribution ws first introduced by Helpmn, Melitz nd Yeple,

16 Hrmoniztion might hve more drmtic effect on the equilibrium s the fixed cost reductions will be more tngible. Firms within the hrmonizing region will no longer hve to comply with every individul stndrd in the re, but only with single one. Initil costs of the liberliztion might differ, since hrmoniztion generlly involves n upwrd dustment of stndrds for prticipnts to the most stringent stndrd in the region (this ws the EU experience, cf. Chen nd Mttoo, 2004). However, this compliction is left side for the moment. Hrmoniztion will be modeled s the elimintion of F X, which implies tht firms will now mke oint entry decisions for ll mrkets in the region. This will give rise to new productivity cut-off S tht will intuitively be less stringent thn the previous two. The new cut-off point cn be derived s follows: the free entry condition will hve to be modified in order to reflect the oint entry decision of firms, which, hving sunk set-up costs once, cn now sell in every country with which technicl regultions hve been hrmonized. We cn write: E E * B + ( h ) φb F (i) D nσ n * σ * Where h is the number of hrmonizing countries. For simplicity, we ssume tht h=2. Replcing the expression for B, we cn then re-write the eqution s: σ σ E E * + φ F (ii) D Δ nσ Δ n * σ * It should be noted, tht we no longer hve two productivity cut-offs, since firms now fce oint entry decision. Following the logic of the model, they will either not enter t ll or enter both mrkets simultneously (this nlysis ssumes wy mrketing costs nd other sunk costs rising from the entry into foreign mrkets; this seems resonble for regions, such s the EU, where integrtion hs lredy progressed to considerble extent in other res nd where hence knowledge of the foreign mrket is lredy good). From the eqution bove, we cn now derive S, the productivity level for which (ii) holds with strict equlity. Solving for S yields the following expression (this is derived in detil in Appendix I): ρ I F D S = 0 (iii) ( 2λ ) which implies tht X < D < S. The result tht hrmoniztion will mke entry for countries in the hrmonizing region less stringent seems obvious. It will be interesting, however to nlyze the impct of such inititives on third countries, in prticulr whether the impct differs ccording to the development level of the country in question. As for third countries with competitive industries (i.e. foreign industries tht cn compete with industries in the hrmonizing region despite bering the dustment cost to the regionl stndrd) it might be the hrmoniztion of stndrds within region tht mkes oint entry into the newly creted, bigger mrket, profitble, while entry into ech individul mrket before hrmoniztion ws not. We should therefore see positive effect on the probbility of entry for both, members of the hrmonizing region nd competitive third countries. As fr s less competitive third countries re concerned, it seems more likely ex-nte tht they will suffer trde reduction. All of the bove conectures re tested below. It should be noted tht the forml derivtion of third-country effects will be highly complex, s discrimintory liberliztion will led to different productivity cut-offs for different groups of countries. Since the originl Melitz (2003) model s it 6

17 stnds is lredy on the edge of nlyticl trctbility, one might hve to consider using simultions in order to predict the effects on third-country producers. SECTION IV Empirics The min fetures of the Melitz model (Melitz, 2003) discussed in the previous section nd on which the empiricl nlysis will be bsed re the following: the representtive firm of the clssic Krugmn (980) trde model is replced by distribution of firms tht differ in terms of their individul productivities. Due to the presence of fixed set-up costs, only frction of the firms initilly prticipting in productivity lottery will find it profitble to produce for the domestic mrket nd gin only subset thereof will be productive enough to lso be ble to export, giving rise to symmetric export ptterns mong countries. 3 The frction of exporting firms from certin country (the extensive mrgin ) will crucilly depend on the size of the fixed export costs s cn be seen from the free-entry condition (equtions 7 nd 7b bove). This feture of the model will llow us to formlize chnges in trde ptterns due to regionl TBT liberliztion in the form of MRAs nd hrmoniztion. The empiricl nlysis is conducted in the frmework of the grvity model. The grvity model is n dpttion to economics of Newton s Lw of grvity, stting tht the volume of trde between two countries depends positively on their economic msses nd negtively the distnce between them. Tking into ccount Melitz (2003), the version of the grvity model presented here dditionlly exploits the fct tht not ll countries trde with ech other nd if they do, those trde flows re not necessrily symmetric. These considertions give rise to two-stge estimtion procedure, s derived in Helpmn, Melitz, Rubinstein (2004; herefter HMR), nd similr to Tobit II model. In ddition to correcting for Heckmn selection bis, HMR use Melitz (2003) to rgue tht correction for bises rising from symmetries in trde flows is lso necessry to obtin consistent results. By explicitly including fixed export costs, their specifiction lends itself to the empiricl investigtion of technicl brriers to trde. In generl, the grvity eqution frmework hs been used to estimte the impct on interntionl trde of interntionl borders (McCllum s (995), Wei (996), Evns (2003) s well s Anderson nd vn Wincoop (2003)) preferentil trding blocs (Frnkel,997) currency unions (Rose, 2000; Tenreyro nd Brro, 2002) membership in the WTO (Rose, 2004; Subrmnin nd Wei, 2004) the size of home mrket effects (Dvis nd Weinstein, 2003) This pper will dd MRAs of testing procedures nd hrmoniztion to the bove list of policy inititives being tested. 3 i.e. if firm is unlucky in the productivity drw, its production costs will be too high to be profitble given the fixed costs it fces in the export mrket nd possibly lso in the domestic mrket. 7

18 It hs often been criticized tht mny versions of the grvity eqution used to this dy lck theoreticl underpinnings. Severl uthors hve mde ttempts to tckle this point of criticism, mong them Anderson (979), Helpmn nd Krugmn (985), Helpmn (987), Bergstrnd (989, 990), Derdorff (998), Feenstr (2002), nd Anderson nd vn Wincoop (2003). However, ll of these theories ssume positive trde between ll trde prtners, symmetric bilterl trde flows nd the sme number of exporting firms cross destintions. 4 Bsed on Melitz s (2003) theory, HMR s version of the grvity eqution, on the other hnd, cn be seen s generliztion of Anderson nd vn Wincoop (2003), ccounting for firm heterogeneity nd fixed trde costs s well s symmetries in export volumes. HMR rrive t the following finl expression for bilterl trde flows s function of country chrcteristics (GDPs: Y i nd Y respectively, price indices: P i nd P h ) nd vrible nd fixed cost trde brriers, τ i nd f i (the full derivtion is presented in the ppendix): ε τ i Vi YiY Pi M = i ε Y J τ h = V h h s h Ph Where V i is proxy for the shre of exporting firms nd is defined s i ε V = dg( ) L for i L, 0 otherwise For the purpose of this nlysis, it should be noted tht the fixed export costs re hidden in the V i s which implicitly contin the level of f i through the productivity cut-offs, (cf. section III). Eqution () cn then be written in log-liner form s m i = (ε-)ln α (ε-)ln c + n + (ε-)p i + y i + (-ε)ln τ i + v i (2) Lowercse vribles represent the nturl logrithms of their respective upper cse vribles, where α determines the elsticity of substitution cross products, Y i is the income of country i nd P i its overll price index, N is the mesure (effectively the number) of firms in country nd c is the cost of country s input bundle. Vrible trde costs, τ i, re ssumed to tke the form of iceberg trde costs. It is further ssumed tht these τ i re stochstic due to unobserved i.i.d. country-pir trde frictions, u i ~ N(0, σ u 2 ). We cn hence write τ i ε- D i γ e -ui where D i is symmetric distnce between i nd. Further, v i is replced by w i, where w i will represent the () 4 Recently, some uthors hve explicitly tken ccount of the mny zero entries in the globl bilterl trde mtrix nd hve suggested theoreticl interprettions of this phenomenon. Among them re Anderson nd vn Wincoop (2004), Evenett nd Venbles (2002) nd Hvemn nd Hummels (2004). Others hve focused on the phenomenon of the extensive versus the intensive mrgin. Eton nd Kortum (2002), for exmple pply similr principle to HMR to determine n ggregte grvity eqution cross heterogeneous Ricrdin sectors. As in HMR s model, the predicted trde volume reflects n extensive mrgin nd n intensive one. However, Eton nd Kortum do not model fixed trde costs nd the possibility of zero bilterl trde flows. Bernrd, Eton, Jensen nd Kortum (2003) use direct informtion on US plnt level sles, productivity, nd export sttus to clibrte model which is then used to simulte the extensive nd intensive mrgins of bilterl trde flows. Yet, unlike HMR, these ppers only ccommodte corrections for individul issues rised by HMR, never ll. 8