While trade liberalization can bring economic gains by improving productivity and welfare, it also has distributional impacts. Research has shown that local conditions, including contract enforcement1, access to credit2, the quality of institutions and the provision of public goods and infrastructure3 are important determinants of who gains and who loses from a reduction in trade barriers. Identifying and understanding these complementary conditions and the channels through which they shape the effects of trade liberalization is crucial to inform policy and ensure that trade benefits all.
In a recent study focusing on Ethiopia4, we conclude that road infrastructure plays a key role in ensuring that trade liberalization results in productivity enhancements for firms, particularly in developing countries. We demonstrate that a drop in input tariffs (import tariffs on intermediate inputs used by firms) is associated with a larger increase in productivity among Ethiopian manufacturing firms in areas with better roads. This is not only because input tariff reductions are magnified when the cost of transporting inputs to firms intra-nationally is lower, but also because firms thereby have improved access to other domestic markets. Resulting changes in demand conditions and greater competition can incentivize firms to adopt new and higher quality inputs or superior technology, all of which can increase productivity.
Roads and trade liberalization in Ethiopia
As a landlocked country with a poorly developed railway system, Ethiopian road transport represents an important mode for the intra-national movement of people and goods.5 The deteriorating condition of the existing road network spurred the Ethiopian government to launch a major infrastructure reform programme: the Road Sector Development Programme (RSDP). The first three phases of the programme from July 1997 to June 2010 involved construction, rehabilitation, upgrading and the maintenance of federal and regional roads by the Ethiopian Roads Authority (ERA) and the Regional Roads Authorities (RRAs).
The figure below shows the road network in 1996 and the new and upgraded roads between 1996 and 2010, respectively, and highlight the towns covered by the sample we analyse in our paper. Using changes to the road network under the RSDP, we construct a measure of intra-national market access that varies across Ethiopian towns and over time.
The RSDP coincided with Ethiopia’s trade liberalization in the early 1990s, which included a dramatic fall in import tariffs. They continued to decrease into the late 1990s and early 2000s, spanning the period of our analysis. This unique timing of reforms enables us to investigate the complementarity between input tariff reductions and road infrastructure improvements in driving firm productivity.
Complementarities between roads and trade liberalization
In our empirical analysis, we relate the physical total factor productivity (TFPQ) of firms to input tariffs, the level of intra-national market access given the existing road network, and the interaction of input tariffs and market access. The estimate value of the latter term is the core result of the paper since it captures the complementarity between input tariffs and roads.
The marginal effect of the input tariff on firm productivity is more negative for larger values of market access. In other words, a reduction in the input tariff is associated with a larger increase in firm productivity as market access increases. To give a sense of the relevance of the relation at stake, our estimates show that 1 percentage point decrease in input tariffs is associated with a 3.1 percentage point higher increase in productivity for a firm with median market access relative to a firm with market access in the fifth percentile. However, the boost from better market access is mitigated for a firm with median market access relative to one with market access in the 95th percentile (a gain of 0.4 percentage points). This suggests that road infrastructure improvements are more beneficial for firms that start out with low market access due to poor roads.
How do better roads complement trade liberalization?
Taken alone, input tariff reductions decrease input prices for firms, incentivizing productivity-enhancing actions that increase firm productivity. Roads can magnify this mechanism in two ways. First, roads shape the pass-through of an input tariff reduction to a decrease in input prices for firms (red arrow). Second, and most importantly, they influence the incentives of firms to take productivity-enhancing decisions in response to the cost advantage generated by these lower input prices (blue arrow).
In our study, we test these two channels and find that a reduction in input tariffs corresponds to (i) a steeper decline in the price of imported intermediate inputs; (ii) a greater likelihood of adopting a new input; and (iii) a higher increase in the capital-to-labour ratio among firms with better market access.
This suggests that roads do not simply magnify firms’ cost reduction from a drop in input tariffs. Rather, the quality of roads determines the degree of market access in the area (town) the firm is located in. Better connectivity to intra-national markets means that, on the one hand, firms can access larger demand. On the other hand, firms compete more intensively with other final goods producers, given that an increase in market access allows consumers to access goods produced by firms in other locations. Greater demand and more competition increase firms’ potential gains from an improvement in TFPQ, increasing incentives to use the cost advantage implied by a reduction in input tariffs to enhance productivity.
A related question is whether a reduction in input tariffs is associated with a differential impact on mark-ups for firms with better market access. We find that—as expected—a reduction in input tariffs is indeed associated with an increase in mark-ups due to lower input costs for firms. However, there is no differential effect on markups for firms with better market access. One way to explain this finding is that opposing forces are at work. On the one hand, cost reductions from a decrease in input tariffs are magnified and firms have greater incentive to improve TFPQ and to lower their marginal costs. This results in higher mark-ups. However, these firms are likely to face more competition, which lowers the mark-ups. Hence, while input tariff liberalization is associated with higher productivity in areas with better market access as a result of road improvements, it is not associated with higher mark-ups.
Conclusions
Road infrastructure improvements are critical in magnifying the gains in firm productivity resulting from a reduction in input tariffs. A novel exploration of the mechanisms reveals that these gains cannot be exclusively attributed to cost reductions from lower input prices amplified by lower transport costs. Instead, road improvements increase access to intra-national markets and thereby incentivize firms to enhance their productivity. Lastly, better market access from road improvements creates a more competitive environment for firms, implying that lower firm costs due to cheaper inputs do not translate into higher mark-ups.
This opinion piece is based on a commentary published on VoxDev on 27 August 2021.
Disclaimer: The views expressed in this article are those of the authors based on their experience and on prior research and do not necessarily reflect the views of UNIDO (read more).
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