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Trade and Investment under Policy Uncertainty: Theory and Firm Evidence

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  • Kyle Handley
  • Nuno Limão

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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17790.

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Date of creation: Jan 2012
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Handle: RePEc:nbr:nberwo:17790

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Citations

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Cited by:
  1. Nicholas Bloom, 2014. "Fluctuations In Uncertainty," Working Papers, Center for Economic Studies, U.S. Census Bureau 14-17, Center for Economic Studies, U.S. Census Bureau.
  2. Gawande, Kishore & Hoekman, Bernard & Cui, Yue, 2011. "Determinants of trade policy responses to the 2008 financial crisis," Policy Research Working Paper Series, The World Bank 5862, The World Bank.
  3. Hoekman, Bernard, 2011. "The WTO and the Doha Round: Walking on Two Legs," World Bank - Economic Premise, The World Bank, The World Bank, issue 68, pages 1-6, October.
  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. Armando Silva & Oscar Afonso & Ana Paula Africano, 2011. "Economic performance and international trade engagement: the case of Portuguese manufacturing firms," GEE Papers, Gabinete de Estratégia e Estudos, Ministério da Economia e da Inovação 0037, Gabinete de Estratégia e Estudos, Ministério da Economia e da Inovação, revised May 2011.
  6. Bown, Chad P., 2010. "Taking stock of antidumping, safeguards, and countervailingduties, 1990-2009," Policy Research Working Paper Series, The World Bank 5436, The World Bank.
  7. Tamini, Lota D., 2012. "Optimal quality choice under uncertainty on market development," MPRA Paper 40845, University Library of Munich, Germany.
  8. Bown, Chad P., 2013. "Trade policy flexibilities and Turkey : tariffs, antidumping, safeguards, and WTO dispute settlement," Policy Research Working Paper Series, The World Bank 6322, The World Bank.
  9. Serguey Braguinsky & Lee G. Branstetter & Andre Regateiro, 2011. "The Incredible Shrinking Portuguese Firm," NBER Working Papers 17265, National Bureau of Economic Research, Inc.
  10. Handley, Kyle & Limão, Nuno, 2013. "Policy Uncertainty, Trade and Welfare: Theory and Evidence for China and the U.S," CEPR Discussion Papers, C.E.P.R. Discussion Papers 9615, C.E.P.R. Discussion Papers.
  11. Handley, Kyle, 2012. "Exporting under Trade Policy Uncertainty: Theory and Evidence," Working Papers, Research Seminar in International Economics, University of Michigan 634, Research Seminar in International Economics, University of Michigan.
  12. Nuno Limão & Giovanni Maggi, 2013. "Uncertainty and Trade Agreements," NBER Working Papers 18703, National Bureau of Economic Research, Inc.
  13. Tamini, Lota Dabio, 2012. "Optimal quality choice under uncertainty on market development," Working Papers, Structure and Performance of Agriculture and Agri-products Industry (SPAA) 148589, Structure and Performance of Agriculture and Agri-products Industry (SPAA).

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