Import Penetration of Low Quality Products : Markups Implications

How are local firms affected by the entry of products that are of low quality and relatively cheaper? China’s exports rose vigorously in the last three decades making it one of the most important trading partners in the world. Most studies argue that China exports low quality varieties of goods produced locally in advanced economies, so that these exports are for most accessible at lower prices. This paper provides theoretical and empirical investigation on the differential impact of the import penetration of low quality products on the market power of local firms with different level of quality. In our theoretical framework, the market hit by international competition is segmented in two groups of firms, those of Low quality and those of High quality. The model also features differential demand elasticity for firms of different size through CREMR preferences. Our theoretical implications suggest that the impact on markup resulting from the import penetration of low quality goods is stronger and negative on local firms producing low quality. This prediction is substantiated by the empirical test we conduct on US Compustat data through a diff-in diff estimation with China accession to WTO as break point. Additional empirical investigation suggests that as they face the competition led by products of low quality, local firms of low quality invest more in innovation to upgrade their level of quality, with convergence to a target. As of local firms of high quality, our results indicate that they invest more in advertising to further signal their relative superiority, with no specific pattern in the way they update their quality input. Overall, our findings suggest that the entry of China in WTO has intensified the competition vertically with firms investing either on advertising or in R&D for signalling or differentiation purposes.