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Trade and Investment under Policy Uncertainty: Theory and Firm Evidence

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  • Handley, Kyle
  • Limão, Nuno

Abstract

We provide theoretical and empirical evidence that policy uncertainty can significantly affect firm level investment and entry decisions in the context of international trade. When market entry costs are sunk, policy uncertainty can create a real option value of waiting to enter foreign markets until conditions improve or uncertainty is resolved. Using a dynamic, heterogeneous firms model we show that: (i) investment and entry into export markets is reduced when trade policy is uncertain, and (ii) preferential trade agreements (PTAs) are valuable to exporters even if applied trade barriers are currently low or zero. We derive a structural equation that predicts how firm entry responds to changes in applied tariffs and a theory-based measure of policy uncertainty. Our novel approach using observable trade policies allows us to estimate the impact of policy uncertainty and quantify its aggregate implications. We apply this method to Portugal's accession to the European Community in 1986 using new firm-level trade data. We find that (i) the trade policy reform accounted for a large fraction of the observed Portuguese exporting firms' entry and sales upon accession (ii) the accession removed uncertainty about future preferences and (iii) this uncertainty channel accounted for a large fraction of the predicted growth. These results have broader implications for other PTAs and our approach can be applied to analyze other sources of policy uncertainty.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8798.

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Date of creation: Feb 2012
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Handle: RePEc:cpr:ceprdp:8798

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Keywords: Investment; Policy; Trade; Uncertainty;

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Citations

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Cited by:
  1. Nicholas Bloom, 2014. "Fluctuations in Uncertainty," Discussion Papers 13-033, Stanford Institute for Economic Policy Research.
  2. Tamini, Lota D., 2012. "Optimal quality choice under uncertainty on market development," MPRA Paper 40845, University Library of Munich, Germany.
  3. Gawande, Kishore & Hoekman, Bernard & Cui, Yue, 2011. "Determinants of trade policy responses to the 2008 financial crisis," Policy Research Working Paper Series 5862, The World Bank.
  4. Florian Mölders, 2012. "On the Path to Trade Liberalization: Political Regimes in International Trade Negotiations," Discussion Papers of DIW Berlin 1245, DIW Berlin, German Institute for Economic Research.
  5. Tamini, Lota Dabio, 2012. "Optimal quality choice under uncertainty on market development," Working Papers 148589, Structure and Performance of Agriculture and Agri-products Industry (SPAA).
  6. Handley, Kyle & Limão, Nuno, 2013. "Policy Uncertainty, Trade and Welfare: Theory and Evidence for China and the U.S," CEPR Discussion Papers 9615, C.E.P.R. Discussion Papers.
  7. Chad P. Bown, 2011. "Taking Stock of Antidumping, Safeguards and Countervailing Duties, 1990–2009," The World Economy, Wiley Blackwell, vol. 34(12), pages 1955-1998, December.
  8. Armando Silva & Oscar Afonso & Ana Africano, 2013. "Economic performance and international trade engagement: the case of Portuguese manufacturing firms," International Economics and Economic Policy, Springer, vol. 10(4), pages 521-547, December.
  9. Bown, Chad P., 2013. "Trade policy flexibilities and Turkey : tariffs, antidumping, safeguards, and WTO dispute settlement," Policy Research Working Paper Series 6322, The World Bank.
  10. Hoekman, Bernard, 2011. "The WTO and the Doha Round: Walking on Two Legs," World Bank - Economic Premise, The World Bank, issue 68, pages 1-6, October.
  11. Serguey Braguinsky & Lee G. Branstetter & Andre Regateiro, 2011. "The Incredible Shrinking Portuguese Firm," NBER Working Papers 17265, National Bureau of Economic Research, Inc.
  12. Nuno Limão & Giovanni Maggi, 2013. "Uncertainty and Trade Agreements," NBER Working Papers 18703, National Bureau of Economic Research, Inc.
  13. Handley, Kyle, 2012. "Exporting under Trade Policy Uncertainty: Theory and Evidence," Working Papers 634, Research Seminar in International Economics, University of Michigan.

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