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Trade and Investment under Policy Uncertainty: Theory and Firm Evidence

Kyle Handley and Nuno Limão ()

No 8798, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Investment; Policy; Trade; Uncertainty (search for similar items in EconPapers)
JEL-codes: D8 D92 E22 F02 F1 F5 H32 O24 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-int
Date: 2012-02
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Related works:
Journal Article: Trade and Investment under Policy Uncertainty: Theory and Firm Evidence (2015) Downloads
Working Paper: Trade and Investment under Policy Uncertainty: Theory and Firm Evidence (2012) Downloads
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