Pass-through of Trade Costs to U.S. Import Prices

One sentence summary: Robust to the consideration of constant versus variable markups, the effects of measured trade costs on U.S. import prices are through source-specific marginal costs of production, with the contribution of quality dominating those of productivity and markups.

Non-technical Summary

Trade costs are partly determined by trade policy, and, thus, their reflection in the welfare of economic agents through prices (i.e., the pass-through of trade costs) is of political interest. Accordingly, the empirical literature on international trade has focused on the effects of changes in trade costs on export prices (of firms or source countries), referring to the gains from trade through export-oriented growth, especially by relying on dramatic liberalizations of trade for identification purposes. Nevertheless, evidence on pass-through of trade costs to import prices is limited, which is important for import competition as well as household welfare in the destination country.

Although calculating the pass-through of trade costs into import prices is straightforward when the corresponding data are available, calculating the underlying details is the key to form trade policy, because, other than the direct effects of trade costs on import prices, one has to consider their indirect effects through other components of prices, namely markups and marginal costs, where the latter also includes information on quality and productivity (in the source country). As a simple example, if more liberal trade leads to an increase in import prices due to an increase in quality, this may be welfare improving in the importer country (depending on the trade-off between increased prices and quality), while an increase in import prices due to a reduction in productivity (with no quality effects) would be welfare worsening. Therefore, in a typical welfare analysis of an importer country, the pass-through of trade costs to prices should be controlled for markup effects as well as quality and productivity effects.

This paper achieves such an investigation by decomposing the U.S. import prices (measured at the U.S. dock) into marginal costs, markups and trade costs at the HTS 10-digit good level. Marginal costs are further decomposed into quality, productivity, and other factors. Using a demand-side model, for robustness, we consider both variable and constant markups in our investigation. After controlling for several fixed effects, we estimate the pass-through of trade costs to prices, markups, marginal costs, quality, and productivity. We also distinguish between the effects of duties and freight-related costs. Moreover, we use actual data on duties and freight-related costs to construct multiplicative trade costs; hence, our results are robust to alternative specifications of trade costs (such as additive trade costs).

When data for prices and trade costs are available (as in this paper), the main issue is the measurement of variables such as markups and marginal costs of production where the latter can further be decomposed into quality, productivity, and other factors (e.g., other local production costs). This paper introduces a new methodology for the identification of all of these variables. In particular, first, the price elasticity of demand is estimated using data on quantities and prices, where an estimation methodology that is robust to simultaneity bias is used. Second, the estimated price elasticities are used to calculate markups, where we consider the cases of both variable markups (due to constant absolute risk aversion utility function of importers) and constant markups (due to constant relative risk aversion utility function of importers). Third, marginal costs of production are identified by using the data on prices and trade costs together with estimated markups. Fourth, quality measures are identified as the importer preference parameters (i.e., demand shifters) that are calculated by controlling the quantities traded for the effects of prices and other control variables (i.e., good-and-time fixed effects). Fifth, since measures of quality and marginal costs of production are shown to be positively related in the literature, the relationship between the estimated measures of quality and marginal costs of production is tested by running a regression where all other factors are controlled for; the part of the marginal costs of production that cannot be explained either by quality or other factors is defined as the inverse of productivity. Once these variables are identified, we continue with investigating their interaction with trade costs.

The results of pass-through analyses show that the elasticity of U.S. import prices with respect to overall trade costs (i.e., duties/tariffs plus freight-related costs) is about -0.90. During an episode of reducing trade costs by 1%, under the assumptions of variable (constant) markups, this corresponds to a 0.90% increase in prices that is decomposed into 1.74% (1.90%) of an increase in marginal costs of production, 0.16% (0.00%) of an increase in markups and 1.00% (1.00%) of a reduction in trade costs (i.e., defined as direct effects of trade costs). The increase in the marginal costs of production 1.74% (1.90%) is further decomposed into 1.10% (1.20%) of an increase in quality, and 0.63% (0.70%) of a decrease in productivity for the cases of variable (constant) markups. Therefore, the contribution of quality has the lion's share in explaining the effects of trade costs on prices, followed by productivity effects and markups.

Considering import competition and/or household utility, if we accept the inverse of import prices controlled for quality as a rough measure of welfare, 1% of a reduction in trade costs would result in 0.20% (0.30%) of an increase in welfare under the assumption of variable (constant) markups. When we decompose trade costs into duties/tariffs and freight-related costs, such values change as -0.21 (0.75) for duties/tariffs and 0.25 (0.22) for freight-related costs, under the assumption of variable (constant) markups. These results show the importance of considering alternative measures of trade costs in pass-through calculations where freight-related costs play an important role, which is mostly ignored in the corresponding literature focusing on duties/tariffs.

The published paper is available at Review of World Economics .