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Trade and Investment under Policy Uncertainty: Theory and Firm Evidence


  • Handley, Kyle
  • Limão, Nuno


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.

Suggested Citation

  • Handley, Kyle & Limão, Nuno, 2012. "Trade and Investment under Policy Uncertainty: Theory and Firm Evidence," CEPR Discussion Papers 8798, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:8798

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    Investment; Policy; Trade; Uncertainty;

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • F02 - International Economics - - General - - - International Economic Order and Integration
    • F1 - International Economics - - Trade
    • F5 - International Economics - - International Relations, National Security, and International Political Economy
    • H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm
    • O24 - Economic Development, Innovation, Technological Change, and Growth - - Development Planning and Policy - - - Trade Policy; Factor Movement; Foreign Exchange Policy

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