Domestic Transportation Infrastructure and Gains from Trade in the Vertical Linkages

Using a two-country Melitz model, we analyze how China's massive railway expansion generates trade gains via vertical linkages. Domestic gains stem from both a composition effect in which improved domestic market access enabled by railway encourages downstream firms to source more inputs domestically and hence raise the domestic value added ratio (DVAR), and a scale effect in which better market access boosts the output level. Intermediate good producers in the foreign country also benefit despite the composition effect, as the scale effect associated with expanded demand from Chinese firms dominates. We test the theoretical predictions with panel data on Chinese manufacturing firms in 2000-2007, addressing endogeneity using a control function approach. Our main empirical findings confirm: (1) Improved upstream access increases exporters' DVAR (explaining 11.57% of its interquantile variation) along with higher value added and revenue; (2) Better access to downstream buyers boosts upstream intermediate producers' value added, profits, and revenue; (3) Foreign intermediate good producers benefit from increased import varieties and quantities of Chinese firms.