Openness to trade and industry productivity dispersion

Gianmarco Ottaviano

31 July 2007



Europe is supposed to become the world’s most competitive knowledge-based economy. Improving Europe’s competitiveness is a complex and elusive task. Improving the competitiveness of Europe’s firms, by contrast, is a concrete goal. More competitive firms are more productive, offering better products at lower prices. More productive firms are also more profitable and, thus, create more value for their shareholders.

Since the very beginning of European integration, integration was always seen as a way of promoting the productivity of European firms. Indeed, an important premise behind the Single Market Program was the belief that, by allowing access to a bigger market, the integration of European economies would make European firms more efficient. In turn, this would allow them to lower prices, raise quality and gain competitiveness in external markets.

Lately we are beginning to get real data – and enough computing power on our PCs – to test these beliefs. Ideally, one would need individual information of the performance of firms collected through surveys and balance sheets in a homogeneous way across European countries. Unfortunately, there is currently no harmonised dataset at the European level covering all the key dimensions one would like to explore, such as productivity, internationalisation strategies and ownership structures. With a growing recognition that only a coordinated effort at the European level will eventually fill the gap, under the coordination of Bruegel and CEPR, eight research centers from eight European countries have created a network to conduct research on firm-level trade and FDI data. The network – EFIM, short for European firms and international markets – has been operating for almost a year and has begun to deliver results.

So far, analyses have focus on individual countries. In my just published Policy Insight, I discuss some of the results for Italy.1 One key result is that the distribution (‘density’) of Italian manufacturing firms across total factor productivity (‘TFP’) levels reveals that exporters are on average more productive than non-exporters. In principle, causality could run both ways. It could be that only the most productive firms export, or that exporting makes firms more productive. The current received wisdom in the theoretical literature assume that productivity causes exporting. In support of this, two stylised facts are often stressed. First, exposure to trade forces the least productive firms to exit the market or to shut down. Second, trade liberalisation leads to market share reallocations towards more productive firms. Indeed, the evidence for this is rather robust (see Bernard and Jensen 1999).

The selection due to international competition determines the impact of trade openness on the distribution of firms across productivity levels. In particular, much attention has been devoted to the mean value of such distribution. For example, an increase in average industry productivity is generally observed as the market becomes more open to distant sellers and less productive firms are forced to shut down. This leads to lower average prices and mark-ups but larger profits for the surviving firms as they are able to expand their scale of operation.

But selection also has implications for the spread of the productivity distribution that causes a compression of prices, mark-ups and profits. While the evidence on the average reaction of productivity to trade shocks is a robust empirical finding, much less is known about its dispersion. Recent research suggests that across Italian manufacturing industries, a two-standard-deviation increase in openness to trade is associated with a 0.9% decrease in dispersion, which is equivalent to a 76% decline when evaluated in terms of openness standard deviation.

The impact of international competition on firm exit and price dispersion within sectors has important implications for the political economy of trade liberalisation. When firm heterogeneity is neglected, within an industry all firms equally lose from trade liberalisation to the advantage of consumers. They therefore have the same incentive to participate in protectionist lobbying. When firms face, instead, very different destinies within the very same sector, the incentive to lobby varies across firms with different market performance. This translates into political economy outcomes that depend on the dispersion of such performance. Accordingly, the extent of firm heterogeneity within an industry affects the clout of protectionist stances and their translation into effective pressure on policy makers. For example, accounting for firm size dispersion and associated differences in lobby participation shares explains a non-negligible fraction of the variation of protection across US sectors (Bombardini 2005). Whether trade openness increases or decreases, the differences between firms then becomes crucial for the political sustainability of the ongoing process of global trade liberalisation.

1 For more detail see CEPR DP6336.





Topics:  International trade

Tags:  competitiveness, total factor productivity, trade openness

Professor of Economics, LSE; Non-Resident Senior Fellow, Bruegel; and CEPR Research Fellow