Exports respond unpredictably to a change in real

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Summary findings

Exports respond unpredictably to a change in real
exchange rates, suggests evidence from the 1980s.

Recent theoretical work (Paul Krugman and Richard
Baldwin) explains this as a consequence of the sunk costs
associatedwith breaking into foreign markets. Sunk costs
include the cost of packaging, upgrading product quality,
establishing marketing channels, and accumulating
information on demand sources.

Roberts and Tybout use micro panel data to estimate a
dynamic discrete-choice model of participation in export
markets, a model derived from the Krugman-Baldwin
sunk-cost hyster --is framework.

Applyingthe model to data on manufacturing plants in
Colombia (1981489), they test for the presence of sunk
entry costs and quantify the importance of those costs in
explaining export patterns. The econometric results
reject the hypothesis that sunic costs are zero.

The results, which control for both observed and
unobserved sources of plant heterogeneity, indicate that
prior export market experience has a substantial effect
on the probability of exporting, but its effect depreciates
fairly quickly. The reentry costs of plants that have been
out of the export market for a year are substantially
lower than the costs of a first-time exporter. After a year
out of the export market, however, the reentry costs are
not significantly different from the entry costs.

Plant characteristics are also associated with export
behavior: Large old plants owned by corporations are
more likely to export than other plants.

Variations in plant-level cost and demand conditions
have much less effect on the profitability of exporting
than variations in macroeconomic conditions and sunk
costs do. It appears especially difficult to break into
fereign markets during periods of world recession.

This paper -a product of the International Trade Division, International Economics Department-is part of a larger effort in
the department to describe the micro foundations of export supply response. The study was fundedby the Bank's Research Support
Budget under the research project "Micro-Foundationsof Successful Export Promotion" (RPO 679-20). Copies of this paper are
available free from the World Bank, 1818 H StreetNW, Washington, DC 20433. Please contactJermifer Ngaine, room R2-052,
extension 37959 (37 pages). March 199S.

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Produccd by the Policy Rescarch Dissemination Ccnter

An Empirical Model of Sunk Costs and the Decision to Export

Mark J. Roberts
Pennsylvania State University


James R. Tybout
Georgetown University

We would like to thank David Card, Terri Devine, Avinash Dixit, Chris Flinn, Zvi Griliches, James
Hanna, James Heckman, Ariel Pakes, David Ribar, Dan Westbrook and an anonymous refree for helpfil
discussions or comments. Support for this paper was provided by the Research Administion
Depatmn of The World Bank (RPO 679-20).


The responsiveness of exports to changes in the incentive structure has long interested policy
makers. But the empirical literature has provided little guidance on when or how exporters will respond
to new incentive structures. Research in this area has produced a variety of supply elasticity estinates
that vary dramatically across countries and time periods, and few hints on how to reconcile the diverse

Paul Krugman and Richard Baldwin haverecently argued that the emirical literature fails because
there are sunk costs associated with breaking into foreign markets -including upgrading product quality,
packaging, and the establishment of marketing channels. Hence the currcnt-period export supply function
depends upon the number and type of producers that were exporting in previous periods. Further, startup
costs mean that transitory policy changes or macro shocks can lead to permanent changes in market
structure, and thus that trade flows may not be reversed when a stimlus is removed. That is, sunk entry
or exit costs produce "hysteresis' in trade flows. Finally, wlhen future market conditions are uncertain,
sum,. costs make pattrns of entry and exit dependent upon the stochastic processes that govern variables
like dhe exchange rate.

Taking the Baldwin/Krugman perspective as a point of departure, this paper develops an
econometric model of a plant's decision to export. The model is fit u mwiro data for a large group of
anufacturing plants in Colcmbia from 1981-1989, and used to direcdy examine the determinants of a

plant's export decision for consistency with the theory.

The econometric results reject the hypothesis that sunk costs are zero. They also reveal that the
re-entry costs of plants that have been out of the export market for a year are substantially less than the
costs of a first-time exporter. Beyond a one year absence, however, the re-entry costs are not
significantly different than those faced by a new exporter. This is consistent with the view that an
important source of sunk entry costs for Colombian exporters is the need to accmulate information on
demand sources, information that is likely to depreciate upon exit from the market.

While the results indicate that sunk costs are a significant source of export market persistence,
both observed and unobserved plant characteristics also contibute to an individual plant's export
behavior. For example, plants that are large, old, and owned by corporations are all more likely to

A number of policy implications emerge. For example, it appears especially difficult to break
into foreign markets during periods of world recession. Also, although only 25 percent of the plants in
the Colombian panel exported during the sample period, the results imply that sufficiently favorable
macro conditions and/or reductions m sunk costs could make exporting profitable for a much larger
proportion of plants. Finaly, and most generaly, the estimates imply that countries undertaldng export
promotion policies should distinguish measures aimed at exanding the export volume of exisitag
exporters from policies aimed at promoting the entry of new exporters.

I. Introduction
Why is it that in some countries and time periods, a given trade and exchange rate regime
supports large scale production for foreign markets, while in other countries or time periods, the same
policies appear to induce a minimal export response? Put differently, whyare cstimates of export
supply equationsso sensitive to the time period or country under study?

In a recent series of papers Richard Baldwin, Paul Krugman, and Avinash Dixit have
proposed an answer.' Thay begin from the assumptionthat non-exporters must incur a sunk entry
cost in order to enter foreign markets. This mnakes the current-period export supply function
dependent upon the number and type of producers that were exporting in previous periods. Further,
it means that transitory policy changes or macro shockscan lead to permanent changes in market
structure, and thus that trade flows may not be reversed when a stimulus is removed. That is, sunk
entry or exit costs produce 'hysteresis" in trade flows. Finally, when future market conditionsare
uncertain, sunk costs make patterns of entry and exit depeodent upon the stochastic processes that
govern variablessuch as the exchange rate. Under plausible assumptions, greater uncertainty makes
trade flows less responsive to changes in these variables. None of these implicationsof sunk costs is
captured in standard empirical export supply functions, and all could contribute to the "instability" of
empirical relationships.2

To date, attepts to empirically validate the sunk-cost hysteresis framework have focussed on

'See, in particular, Dixit, 1989a and 1989b; Baldwin, 1988 and 1989; Baldwin and Krugman, 1989; Krugman, 1989).

2In their review of empirical studies of price and income elasticities for traded goods, Goldstein and Khan (1985, pp.
1087-1092)report a very wide range of estimates for the supply elasticity of total exports from developed countries. They
conclude that 'excluding the United States, the supply-price elsticity for the total exports of a representative industrial
countly appears to be in the range of one to four. The supply elasticity for U.S. exports is probably considerably higher
than that, perhaps even reaching ten to twelve.' They also discuss some evidence indicating that the response of export
supply to price changes is slower than demand-side adjustments. They speculate dh this may refict start-up costs
associatedwith export production or greater unceUity assocated with sHling abroad.


asymmetries in the response of trade flows to exchange rate appreciation versus depreciation.3 A

limitation of this approach is that data on the volume of trade flows, even for very disaggregated

commodities, cannot distinguish the entry and exit of exporters from the supply response of

continuing exporters. With the exception of Campa (1993), the foreign market entry and exit

patterns, which are the focus of the theory, have not been exanined for consistency with the sunk-

cost hysteresis model.'

In this paper we develop an empirical test of the sunk-cost hysteresis model that directly

examines entry and exit patterns in plant-level panel data. We develop and estimate a dynamic

discrete choice model of the decision to export when sunk entry or exit costs are present. In essence,

this model predicts exporting status in the current period as a function of plant characteristics,

previous exporting status and a serially correlated disturbance. It not only permits us to formally test

for the presencc of sunk costs (using coefficients on lagged exporting status), it allows us to

summarize the effects of time, individual producer characteristics, and prior exporting experience on

the probability of participating in the export market. The data we use describe the export patterns of

I The empirical evidence derived from trade flow data has produced no clear consensus. Basedon aggregate U.S. data,
Baldwin (1988) concludes ftat the substantial appreciation of the U.S. dollar during the early 1980's resulted in a structural
shift in U.S. impon pricing equations. This is consisteant with sunk-cost hysteresis. In contrast, Gagnon (1987) finds that
trade has been more responsive to relative prices in the more uncertain post-Bretton Woods era, a result inconsistent with
some versions of the hysteresis model. Using time-series data for U.S manufacturing industries. Feinberg (1992) fmds that
exports became more dispersed across destination markets as the dollar depreciated, suggesting that there was firm entry
into new country markets. The effect was weaker in industries where distribution networks, and thus presumably sunk entry
costs, are more important. Parsley and Wei (1993) focus on bilateral U.S.-Canada and U.S.-Japan trade flows fbr very
disaggregated commodities. They find that both the past history of U.S. exchange rate changes and measures of exchange-
rate volatility had no significant effect on trade flows. Both findings ar inconsistentwith the hysteresis model.

' Campa (1993) examines the number of foreign firms that made direct investnents in the 61 U.S. wholesale trade
industries over the 1981-87 period. He finds that exchange-rate uncertainty, which is proxied by the stndard deviation of
the monthly rate of growth of the exchange rate, is negatively cormlated with the number of firms investing in the U.S..
He also reports that an industry's sunk costs, which arc proxied by the advertising-sales ratio and ratio of fixed assets to net
worth of firms in the industry, is negatively correlated with foreign-firm entry. Both findings are consistent with the
hysteresis model. Although not in a trade context, related work by Bresnahan and Reiss (1991, 1994) shows how data on
net entry into a market can be used to make inferences about the ratio of sunk entry and exit costs to avenge profitability.
Their technique exploits the asymmetric response of the number of producers to population (demand) changes across
diffierent geographic markets. However, as they acknowledge, persistance in behavior due to permanent cross-producer
differences in profitability can create the appearance of sunk costs in their model.


Colombian manufacturing plants in four major exporting industries over the period 1981-1989, a nine-
year span characterized by substantial changes in aggregate demand and real exchange rates.

The empirical results strongly reject the hypothesis that sunk costs are zero. This implies that
prior export market experience significantly affects the current decision to export. Further, although
recent experience in foreign markets is extremely important, its effect depreciates fairly quickly over
time. A plant that exported in the prior year is up to 40 percentage points more likely to export in
the current year han an otherwise comparable plant that has never exported. But by the time a plant
has been out of the export market for two years its probability of exporting differs little from that of a
plantthat has never exported.

Severalpolicy implications emerge. First, although only 25 percent of the plants in our panel
exported during the sample period, our results imply that sufficiently favorable macro conditions
ador reductions in sunk costs could make exporting profitable for a much larger proportion of
plants. Second,our estimates imply that countries undertaldngexport promotion policiesshould
distinguishmeasures aimed at expanding the export volume of exisitng exporters from policies aimed
at promoting the entry of new exporters.

In the next section of the paper we summarize the theoretical sunk-cost model. The third
section provides an overview of the patterns of export participation among Colombian man uri
plants between 1981 and 1989. The fourth section develops an econometric model of the export
decision,and the fifth section presents our results. We briefly summarize and draw conclusions in
the sixth section. Readers uniterested in methodological issues may wish to skip section E and
readers uninterested in econometric problems may wish to skim section 1".

A Theoretical Model of Entry and Exit with Sunk Costs
As reviewed in Krugman (1989), sunk costs affect the export supply function for several

reasons. First, and most obviously, once the sunk costs of entering a market have been met, a
producerwill remain in that market as long as operating costs are covered. This implies that changes
in policy, exchange rates, or prices in foreign nmarkets can permanently alter market structure and
thusobserved export behavior. For example, devaluations that induce entry into the export market
may permanently increase the flow of exports, even if the currency subsequently appreciates.
Second, even if current conditions appear favorable to exporting, they may not induce entry into the
export narket if they are regarded as transitory. In this case, the expected future stream of operating
profits may not cover the sunk costs of entering foreign narkets. Thus large devaluations may induce
littleresponse from potential exporters if they are perceived as transitory. Finally, as formally
demonstratedby Dixit (1989a), the combination of sunk costs and uncertainty about future market
conditionscan create an option value to waiting. Dixit's simulation resdts suggest that even small
amouts of uncertity can significantly magnify the degree of persistence in a producer's expordng

To motivate our empirical work, we begin by reviewing the theoretical models that generate
these results (see footnote 1 for references).For each period t, le, the ti plant's expected gross
profits when exporting differ from its expected gross profits when not exporting by the amount
ir,(o,sJ. Here p, is a vector of market-level forcingvariables that the plant takes as exogenous (e.g.,
the exchange rate), and s,,is a vector of state variables specific to the plant (e.g., capital stocks and
geographiclocation). Once in the market, plants are assumed to freely adjust export levels in
response to current market conditions (Baldwin,1989). Thus the functionT#,,Sd represents the
increment to expected profits associated with exporting in year t, assuming that the profit-maximizing
levelof exports is always chosen.

These profits are gross because they have not been adjusted for the sunk costs of foreign
mariet entry or exit. Assume that if the i* plant last exported in year t-j (j 2 2) it faces a re-entry


cost of F , so upon resuning exports in year t it earns r1(plsd -Fl . Similarly,If the plant had
never exported previously, it faces an entry cost of P57andearns ir1(p,,sJ-P7 in its first year
exporting. Finally, a plant that exported in periodt-1 earns r,(p,,sd)during period t by continuingto
export and -X, if it exits. As in Dixit (1989a), these sunk costs represent the direct monetarycosts of
entryand exit. The j superscriptgeneralizes previous models to allow sunk re-entrycosts to depend
on the length of absence from the market. This could reflect the increasing irrelevanceof the
knowledge and experiencegained in earlier years, or the increasing cost of updatingold export
products. The i subscript allows sunkcoststo vary acrossplants with differencesin size, location,


previouscxperience,and other plantcharacteristics.

To collapsetheseearningspcwsibilitiesinto a single expression,define the indicatorvariable
Yi to take a value of 1 if the plant is exportingin period t, and 0 otherwise. Also,let the exporting
history of the plant through period t be givenby Yki, = (Y,,I j=O...J 3, whereJ1 is the age of the
plant. Tbenperiodt exporting profitsare:

Rsd2i;') = r p -F°(IY) -S (Fi-F ?)I,-ff]-X,Y,,I(1-Y1Y)

= (Y,where P, f (I *) .Y This last expression summarizesthe plant's most recent

exportingexperience: , = 1I whenthe plant's most recent exportng experienceoccurredj years,

earlier and 0 otherwise.
In period t. managersare assumed to choose the infinite sequence of values11,= (Yk,+,I i
2 0) thatmaximizesthe expected presentvalueof payoffs. In period t, this maximizedpayoff is:

5To keep ie notation ttable we have not added a tiwe bscrit to entry and exit costs. Inbe emp section, we
will st whether hy vary over ime, as would be expected if there are changes in credit market condions or trade policis
that affect accessto frig markets.


j of

max E, 6-1R Q>


where6 is the one-period discount rate and expectations are conditioned on the plant-specific
informationset, 0 1, Using Bellman's equation, plant i's current exporting status can be represented
as the Y,, value that satisfies:

vt,(Od = 1 ,( )e.) + 5E,{V...(Q,, 1


where E, denotes expected values conditioned on the information set 0,,. From the right-hand side of
this expression, it follows that the iuhplantwill be in the export market during period t if:

IAStsfi} + 5[E1(V,(fl,. 1) 1Y=1) -E,(VZ.1(O.1) I4=0)]2

F ° -(F0+.Xi) Y,,- + (Fill-F, ) Y,


where -fl;: + X,)is the sum of sunk entry costs for a plant that never exvported andexit costs for
current exporters, sometimes referred to as the "hysteresis band" (Dixit, 1989a).

Equation(1) provides the participation condition that will be estimated in section V. It has
severalempirical implications we will pursue. First, if there are no sunk costs, the participation
condition collapses to ri(p,si) > 0. Hence one can test the sunk-cost hysteresis framework by asking
whether,given a plant's current gross profits, its exporting history helps explain its current exporting
status. Second, if sunk costs do matter, equation (1) implies that they appear directly in each plant's
participationcondition as coefficients on binary variables that describe its exporting history.6 Hence
the magnitude of sunk costs and the rate at which past experience depreciates can be identified.

6The influence of sunk costs aLso comes through the expected value term on the left-hand side, but since this is a nonlinear
expression. coefficients on die indiaor variables are idtified.


Finally,this equation indicates that realizations on the variables p, and s3 , influence export decisions
through their effect on w(p,,sdand their effect on the expected future value of becoming an exporter
now. Th1islatter effect implies, for example, that exchange rate movements that managers consider
transitory will generally have less effect than equivalent movements that are viewed as long-term
regime shifts.

m. The Pattern of Export Participation in Colombia
Before discussing estimation issues and results, it is useful to introduce our data base, review
the export enviromnent in Colombia, and provide some aggregate evidence on the pattern of export
maiket participation during the 1980s.

The Data: The analysis in this paper is based on annual plant-level data collected as part of
the Colombian manufacturing census for the years 1981-1989. This census, which covers all plants
with 10 or more employees, provides information on each plant's geographic location, industry, age,
ownership structure, capital stocks, investment flows, expenditure on labor and materials, value of
output sold in the domestic market, and value of output exported. We have matched the individual
plant observations across years to form a panel.7 The data are particularly well-suited to analyzing
export market participation because they allow us to observe transitions of individual plants into and
out of the export market and to control for some important observable plant characteristics that are
likely to affect the export decision.

The Policy Regime and Export Particpation Rate: Table1 illustrates the basic paterns

7Thecensus data and matching process are discussed in greak, detail in Roberts (1994).


over the sample period for the 19 major exporting industries In the Colombian manufacturing sector.'
In general tenns, the macro environment in Colombia was not conducive to profitable exporting of
manufacturedgoods in the early 1980's. Responding to illegal exports, foreign capital inflows, and a
boom in the coffce market, the Colombian peso appreciated steadily between the mid-1970's and
1983. As shown in Table 1, this pattern was reversed aftr" 1983, with the currmncy losing
approximatelyone-half of its value by lY89. This partly reflected central bank currency market
interventionsto ease competitive pressures on tradeable goods producers.

The time-series pattern of manufactured exports largely mirrors this movement in the
exchange rate. The real value of manufactured exports from the nineteen major exporting industries
declined slightly from 109.6 (billion 1985 pesos) in 1981 to 95.9 in 1984, for an average annual
growth rate of -4.45 percent. F-rom 1984 to 1989 the pattern reversed and the quantity of exports
grew at an annual average rate of 21.1 percent."

Commercial policy sheltered import-competing producers throughout the sample period.
Substantial tariff barriers were reduced slightly after 1984, but quantitative restrictions on the imports
of products that competed with domestic industries were maintained. In addition to turning the terms
of trade against exporters, these polices made it more difficult to import raw materials or capital
goods that may have been necessary to increase the quality of manufactured products.'"

9 The nineteen industries and their SITC codes are: food processing (311/312), textiles (321), clothing (322). leathr
products(323/324).paper(341), printing (342). chemicals (351/352), plastic (356). glass (362). non-metal products (369).
iron and steel (371). metal products (381), nuchinery(382/383), transportation equipment (384), and miscellaneous
nianuficuring(390). These industries account forover 96 percent of Colombia's manufacturing sector exports and 85
percent of manufacturing output in each sample year.

' The real value of exports is measured as the peso value of exports deflated by an export price index from the IMF
InternationalFinancial Statistics. This measure will overstate the dependence of the physical v.;:ume of exports on the
exchange rate because of valuation effects.

"0 The long-term promection of the domestic market from import competition appears to have alo contributed to the low
product quality and low productivity that have made it difficult for Colombian exporters to compese in the intentional
market (World Bank, [992).


Nonetheless, the bias toward import-competing activities was partly offset by export subsidies, which
increased relative to the value of exports by approximately 50 percent between 1983 and 1984, and
thereafter declined." The incentives to export created by export policy therefore were counter to
those created by exchange rate movements.

The net effect of these changes on the number of exporting plants and the proportion of plants
that exported is summarized in the last two rows of Table 1. Again, the time-series pattem largely
reflects the movement in the exchange rate. Through 1984, there was net exit from the export
market, and a decline in the proportion of plants exporting. After that year there was net entry and a
steady increase in the participation rate. There is, however, some evidence of asymmetry in the
magnitude of the response. The modest 6 percent real appreciation between 1981 and 1983 was
accompanied by a decline in the export participation rate from .129 tc .113, but a much larger (45
percent) depreciation between 1984 and 1989 served only to increase the participation rate to .135.
From this short time series it appears that it took both a substantial and persistent devaluation to
induceentry into the export market. This is consistent with the conjecture that potential exporters
faced substantial start-up costs.

Survey evidence further suppons this hypothesis.'" First, to sell in developed country
markets, Colombian producers wera often required to invest in product quality upgrading. Second,
therewas little exporting infrastucture in the form of trading companies or distribution agents. These
companies typically provide transportation, customs, and shipping services, as well as information on

" This reduction in export subsidies reflected a reduction in two government programs used to promote exports. The
first program rebates customs duties paid on imported materials and capital equipment for plams that export. In 1980 41
percent of the value of exports came from plants that received rebates. This rose to 62 percent in 1984 and fell to 53
percent in 1986. The second program provides direct subsidies to exporters based on the value of their exports. The
average rate of subsidy increased from 7.6 percent of the value of exports in 1981 to 15.0percent in 1985 and tben fell to

8.7percent in 1986.
I2 lThe discussion in this section is based on World Bank (1992), which summarizes and interprets interviews with

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