Trade Barriers

Trade barriers prevent higher trade on both the intensive and extensive margins, with barriers to market entry in particular affecting trade on the extensive margin. Crozet & Koenig (2010) find that, on average, the extensive margin channels 74% of the impact of trade barriers on total trade.

3.4.1 Variable Trade Costs and their Effect on the Extensive Margin
Variable trade costs affect the number of trading partners for homogenous goods more than for differentiated/innovative goods, resulting in trading networks with fewer trading partners. For differentiated/innovative products trading networks tend to be wider. As noted above, studies using a gravity model have found that trade costs associated with distance affect all aspects of the extensive margin more than the intensive margin. Variable trade costs, including transport costs, will affect trade on the extensive margin, in terms of the number of country trading partners, more for homogenous goods than for differentiated/innovative goods. Since homogenous goods are more easily substitutable and compete more on price, these goods will tend to be exported from a country that is geographically close to the recipient market and that has low bilateral trade barriers with the recipient country. Those exporting countries with high transport and trade costs will find it difficult to compete on price and therefore the low volume of demand for their products will not justify the fixed costs of entering the market. Differentiated products are less easily substitutable and therefore even those exporting countries with high transport and trade costs with the recipient country may find it beneficial to enter the market, depending on the size and nature of demand in that market. A preference for variety could provide sufficiently price inelastic demand for their products to be sold at a level which can cover costs and still be profitable. Trade networks are therefore likely to be significantly wider, both geographically and in terms of the number of trading partners,for differentiated products. These results imply that homogenous goods are often sourced from regional trading partners and that, despite the perception that international competition in the world markets is stronger in industries producing more homogenous goods; this tendency can be tempered by the effects of distance and transport costs.

Even at aggregate level the world trade network is largely incomplete, with a density of about 0.44. Unsurprisingly, at sectorial level the density is much more lowered, being on average about 0.19. So in a given industry, on average there is a probability of 19% that two countries are linked.

Benedictic and Tajoli (2009) investigate the concentration of trade flows and the role of particular countries in trade networks. They find that the largest industrialized markets still account for a large proportion of total imports across most sectors, and play a dominant role in the import network. However, in exports, for quite a few sectors, source countries can be highly concentrated among smaller countries and emerging Asian economies. Therefore, the level of GDP has down marketed to the role of a country as an exporter in a particular trade network. In the sectors like trading, the country can play a key role in the trade network independently from its size or level of development. They also find that, as the complexity of the goods produced in a given industry increases, the number of links in the trade network initially increases, as the number of countries exporting and importing the goods rises, and the trade network becomes more complex. However, this relationship is non-linear; eventually, as complexity increases even further and differentiation requires a high level of specialization, the number of countries trading these goods declines to some extent.

Currency Unions and Exchange Rate Pegs

Bergin and Lins (2008) panel data analysis of the period 1973-2000 indicates that currency unions have raised trade predominantly at the extensive margin, with the entry of new firms or products. In contrast, direct exchange rate pegs have worked almost entirely at the intensive margin, increasing trade of existing products. This phenomenon is attributed to the more durable nature of currency unions, which therefore encourage firms to make the longer-term investment needed to enter a new market. Their model predicts that when exchange rate uncertainty is completely and permanently eliminated, all of the adjustment in trade should occur at the extensive margin.

3.4.2 Barriers to Market Entry and the Extensive Margin

Fixed costs of market entry have a larger impact on the extensive margin than on the intensive margin of trade. The effect is larger for differentiated/innovative

goods than for homogenous goods, and the share of exports explained by the extensive margin is larger in these sectors.

The fact that why all countries dont trade with each other? The reason for this is that most firms do not engage in trade, and that those who do are larger and more productive than those who do not, all point in the direction of significant fixed costs of entering foreign markets. The more productive a firm, the more likely it is to recover the fixed costs of entering a foreign market. Fixed costs or entry barriers include both policies; regulation in the importing country, such as licenses and standard requirements & economic barriers such as search costs for a local partner or the building up of local distribution channels. In the Help man, Melitz and Rubinstein (2008) framework, these fixed costs are inferred from their effect on the extensive margin of trade.. Hlousek (2009) studies the increase in trade between Visegrad countries and the EU-15 following trade liberalization, and finds that the growth in exports was mainly on the t previously been trading. Our analysis of UK data above support this conclusion at the firm level: There was a large increase in the number of UK goods exporters entering New Member State between2002-2008.

Smeets et al (2010) study 1,200 large Dutch firms in 2006-2007, and find that market entry costs play a prominent role in the decision to enter a market. Only a quarter of the firms sampled export to more than 50 markets. These firms account for 60 per cent of the export value, suggesting that only the larger or more productive firms export to a wider range of markets. 9 per cent of the sample exported to only one destination. Smeets et al consider different market entry costs and find that low levels of institutional and regulatory quality, corruption and cultural dissimilarity are important barriers to entering export markets. However, they have little influence on the subsequent decision on export volumes. They also find some evidence that these market entry cost effects on the export decision are relatively important when considering entering small markets. Exports to large markets, on the other hand, react more strongly to changes in trade and transport costs.

Andersson (2007) examines Swedish firm-level export data and finds that fixed costs have a larger impact on the extensive margin than on the intensive margin of trade. Moreover, the impact of fixed cost trade barriers on the extensive margin, in terms of the number of firms engaging in trade, is larger for differentiated goods than for homogenous goods. Differentiated goods often require higher search costs for local partners, higher costs of adaptation to local markets, and are more complex to test

against local standards. Homogenous goods, on the other hand, are more greatly affected by variable costs such as tariffs and transport costs, since these affect their ability to compete on price, as discussed in Section 4.3.1.

Rauch (1999) also finds that entry barriers have a lower impact on exports of more homogenous goods (eg goods traded on organised exchanges or that have a reference price). He argues that acquiring information about differentiated goods is costly, so that differentiated goods effectively face a higher entry barrier.

Koenig (2005) studies French firms and finds that the distance elasticity of the amount exported by an individual firm (the intensive margin) is larger in sectors where goods are more homogenous, whereas the distance elasticity of the number of firms (the extensive margin) is smaller in sectors where goods are more homogenous. This finding appears to contrast with the finding, reported in the previous section, that at the country level, extensive margin effects of distance-related variable costs are larger for homogenous goods. This suggests that the fixed costs of entry arising from distance can dominate the effect of variable costs on the extensive margin at firm level, and, as argued by Rauch, that these fixed costs are greater for firms selling differentiated products. Consistent with this idea, Koenig also finds that the share of exports explained by the extensive margin, in terms of the number of firms exporting, is larger in sectors with more differentiated products.

NIESRs 2010 secondary analysis of the International Business Strategies, Barriers, and Awareness survey confirmed that innovative firms report a significantly higher number of market entry barriers. Innovation was found to be the only consistent predictor of the number of barriers a firm faces. In terms of the severity of barriers faced, innovation was again the most significant influence, with innovative firms more likely to report more severe barriers, particularly with respect to contacts, establishing an initial dialogue, and building relationships with key contacts. This appears to be true across markets, suggesting that in any one market, innovative firms face higher barriers than non-innovative firms. However, highly innovative firms were also more likely to enter the BRICs and other emerging markets than non-innovative firms, and these markets are likely to entail higher entry barriers for UK firms than, for example, established European markets. The result that innovative firms are more likely to venture into emerging and distant markets also supports the conclusions of Benedictis & Tajoli (2009), that innovative/differentiated products tend to have geographically wider trade networks.

3.4.3 The Effect of the Elasticity of Substitution

Aggregate trade flows are less sensitive to changes in trade barriers when goods are more substitutable.

When transport costs vary, not only can each exporter respond by changing the size of its exports (the intensive margin), but the set of exporters is likely to vary as well (the extensive margin). Chaney (2008) finds that the price elasticity of substitution in demand has opposite effects on each margin. A higher elasticity makes the intensive margin more sensitive to changes in trade barriers, whereas it makes the extensive margin less sensitive. When trade barriers decrease, new and less productive firms enter the export market. When the price elasticity of substitution is high, a low productivity is a severe disadvantage. These less productive firms can only capture a small market share. The impact of those new entrants on aggregate trade is small. On the other hand, when the elasticity is low, each firm is sheltered from competition. The new entrants capture a large market share, and the impact of those new entrants on aggregate trade is large. So a higher price elasticity of substitution increases the sensitivity of the intensive margin to changes in trade barriers, whereas it dampens the sensitivity of the extensive margin. Chaney (2008) shows that when the distribution of productivity across firms is Pareto (a good approximation of the observed distribution of US firms) the effect on the extensive margin dominates. The elasticity of aggregate trade with respect to trade barriers (both variable and fixed) is negatively related to the elasticity of substitution. Therefore, when the elasticity of substitution is low, a reduction in barriers to entry for UK firms in China will result in more UK firms entering the Chinese market (as well as existing exporters exporting larger volumes), and a large increase in overall UK-China exports, potentially increasing the UKs market share. As such, the effect of trade barriers on trade flows is magnified by the elasticity of substitution. Aggregate trade flows are less sensitive to trade barriers when goods are more substitutable (Chaney, 2008).

A high elasticity of substitution also translates productivity differences into large differences in the size of exporting and non-exporting firms. As firm sizes become more dispersed, fixed costs have a lesser impact on exports: large firms can easily overcome those fixed costs.

3.4.4 Barriers to Entry in Services

Services do not go through customs and cannot be observed crossing a border. However, there are considerable trade barriers behind the border, related to compliance with regulation, which require considerable resources on the part of the exporter. Such costs are usually independent of subsequent export flows and must therefore be considered as fixed and largely also sunk. Service providers typically need a licence to operate. In some service sectors, such as professional services, local qualification requirements need to be fulfilled and documented, and compliance with local standards is required. This constitutes a sizeable barrier if firms need to go through different screening and qualification procedures for each new market they enter. In addition, services are often highly differentiated, so likely to face higher fixed costs of market entry. Hence the share of exports explained by the extensive margin, in terms of the number of firms exporting, is likely to be larger in these sectors.

3.4.5 Comparison of Barriers among OECD Countries

The OECD product market regulation (PMR) indicators provide a regulatory profile of the member countries on a number of dimensions, including explicit barriers to trade and investment, competition issues, red-tape and government intervention in the economy. In addition to such regulatory barriers to entry, there are more commercial entry costs such as market research and customizing the services to local preferences. Given the role of service trade in supporting goods trade, service trade barriers are likely to have a bearing on trade costs in goods and vice versa. While all OECD countries have carried out reforms to reduce product market regulation barriers, there remains significant variation in the extent of these barriers, and the ranking among member countries has changed somewhat. The USA had just overtaken the UK in 2008 as the member country with the lowest regulations, while Spain, Japan, Switzerland, Italy and the Czech Republic improved their regulation index by the largest proportion between 1998 and 2008. This is shown in Figure 3.3 below.