Imported Intermediate Inputs and Domestic Product Growth: Evidence from India

TL;DR: In this paper, the authors investigate the relationship between declines in trade costs, imports of intermediate inputs, and domestic firm product scope, and find that lower input tariffs account on average for 31% of the new products introduced by domestic firms.

Abstract: New goods play a central role in many trade and growth models. We use detailed trade and firm-level data from India to investigate the relationship between declines in trade costs, imports of intermediate inputs, and domestic firm product scope. We estimate substantial gains from trade through access to new imported inputs. Moreover, we find that lower input tariffs account on average for 31% of the new products introduced by domestic firms. This effect is driven to a large extent by increased firm access to new input varieties that were unavailable prior to the trade liberalization.

Summary

1. Introduction

• New intermediate inputs play a central role in many trade and growth models.
• Hence, the authors conclude that input tariff liberalization contributed to domestic product growth not simply by making available imported inputs cheaper, but, more importantly, by relaxing technological constraints facing such producers via access to new imported input varieties that were unavailable prior to the liberalization.
• These findings relate to two distinct, yet related, literatures.
• This leads to imports of new varieties of intermediate products, which in turn enables the creation of new domestic varieties.

2.1 Data Description

• The firm-level data used in the analysis are constructed from the Prowess database which is collected by the Centre for Monitoring the Indian Economy (CMIE).
• Product-level information is available for 85 percent of the manufacturing firms, who collectively account for more than 90 percent of Prowess’ manufacturing output and exports.
• For each industry, the authors create an input tariff for that industry as the weighted average of tariffs on inputs used in the production of the final output of that industry.
• While there was significant variation in the tariff changes across industries, Topalova (2007) has shown that output and input tariff changes were uncorrelated with pre-reform firm and industry characteristics such as productivity, size, output growth during the 1980s and capital intensity.

3. Reduced Form Results

• This section presents some descriptive and reduced-form evidence on the relationship between tariff liberalization and product scope.
• Even without making any particular assumptions about market structure or functional forms, it is easy to see how a reduction in input tariffs would affect a firm’s decision to introduce a new product.
• In section 4, the authors place additional structure on the firm’s production function in order to quantify the specific channels generating the reduced form findings.
• The goal of this analysis is to show that the extensive product margin was an important component of import growth (especially for intermediates) and that trade liberalization affected the variables relevant in their framework in expected ways.
• Total import growth reflects the contribution of two margins: growth in HS6 products that existed in the previous period (intensive margin) and growth in products that did not exist in the previous period (extensive margin).

3.1.2 Import Volumes, Prices and Varieties

• The authors next examine whether the expansion in trade noted in Table 2 was systematically related to the tariff reductions induced by India's trade liberalization.
• Since their results are robust to alternative definitions of a variety, the authors focus their discussion on the results in Panel A.18 Column 1 estimates equation (7) for all products and shows that tariff declines were associated with an increased number of imported varieties.
• Specifications 1 and 2 of Table 4b introduce NIC2-year and NIC3-year pair fixed effects, respectively, to control for pre-existing sector-specific trends.
• As before, the input tariff coefficient remains stable and statistically significant.
• 2.2. Input Tariffs and Other Firm Outcomes.

4 Mechanisms

• The results presented in the previous section quantify the overall impact of access to imported inputs on firm scope and other outcomes.
• Having established that variety growth has a substantial impact on the import price index, and that this effect is particularly pronounced in the intermediate goods sector, the authors next turn to quantifying the relative importance of the price and variety margins in the expansion of domestic product scope.
• Column 3 reports the results using only the conventional input price index; this is the IV version of column 1 in Table 6a.
• Column 5 presents the results when equation (19) is estimated with IV and both indices are included; this equation is just identified with the two instruments and two endogenous regressors.
• These regressions (available upon request) yield very similar coefficients to those reported in columns 4-7, suggesting that their assumption that input tariffs affect firms’ product scope only through the conventional input price and variety index is valid.

5. Conclusion

• After decades of import substitution policies, Indian firms responded to the 1991 trade liberalization by increasing their imports of inputs.
• The authors use a unique firm-level database that spans the period of India’s trade liberalization to demonstrate that the expansion in domestic product scope can be explained in large part by the increased access of firms to new imported intermediate varieties.
• The authors believe that relying on aggregate productspecific import data rather than firm-level data on input use offers a few advantages.
• Second, firms frequently access imported inputs through intermediary channels rather than direct imports; hence, it is possible that a firm that reports zero imported intermediates is in fact using 30 We estimated equation (19) for output, TFP and R&D activity.the authors.the authors.
• The counterintuitive sign on TFP could in part reflect the difficulties associated with measuring TFP noted in the introduction.

Figures

Table 3b: Import Unit Values and Tariffs

Table 1: Pre-reform Firm Characteristics and Input Tariff Changes

Table 2: Decomposition of Import Growth, 1987-2000

Table 5: Import Variety Indices

Table 3b: Import Unit Values and Tariffs

Table 6a: Product Scope and Channels: OLS

Table 3b: Import Unit Values and Tariffs

Full text

Imported Intermediate Inputs and Domestic Product Growth:
Evidence from India
by
Pinelopi Goldberg, Princeton University
Amit Khandelwal, Columbia GSB
Nina Pavcnik, Dartmouth College
Petia Topalova, IMF
CEPS Working Paper No. 192
September 2009

1
Imported Intermediate Inputs and Domestic Product Growth:
Evidence from India
1
Penny Goldberg
Princeton University
BREAD, NBER
Amit Khandelwal
Columbia GSB,
BREAD, NBER
Nina Pavcnik
Dartmouth College
BREAD, CEPR, NBER
Petia Topalova
Asian and Pacific Dept,
IMF
First Draft: October 2008
This Draft: September 2009
Abstract
New goods play a central role in many trade and growth models. We use detailed trade and firm-
level data from a large developing economy—India—to investigate the relationship between
declines in trade costs, the imports of intermediate inputs and domestic firm product scope. We
estimate substantial static gains from trade through access to new imported inputs. Accounting for
new imported varieties lowers the import price index for intermediate goods on average by an
additional 4.7 percent per year relative to conventional gains through lower prices of existing
imports. Moreover, we find that lower input tariffs account on average for 31 percent of the new
products introduced by domestic firms, which implies potentially large dynamic gains from trade.
This expansion in firms' product scope is driven to a large extent by international trade increasing
access of firms to new input varieties rather than by simply making existing imported inputs
cheaper. Hence, our findings suggest that an important consequence of the input tariff
liberalization was to relax technological constraints through firms’ access to new imported inputs
that were unavailable prior to the liberalization.
Keywords: Intermediate Inputs, Firm Scope, Multi-product Firms, Product Growth, Gains from
Variety, Endogenous Growth, Trade Liberalization, India
*
We thank Matthew Flagge, Andrew Kaminski, Alexander Mcquoid, and Michael Sloan Rossiter for excellent
research assistance and Andy Bernard, N.S. Mohanram, Marc Melitz, Steve Redding, Andres Rodriguez-Clare,
Jagadeesh Sivadasan, Peter Schott, David Weinstein, and several seminar participants for useful comments. We are
particularly grateful to Christian Broda and David Weinstein for making their substitution elasticity estimates
available to us. Goldberg also thanks the Center for Economic Policy Studies at Princeton for financial support.
Correspondence to Goldberg at pennykg@princeton.edu, Khandelwal at ak2796@columbia.edu, Pavcnik at
nina.pavcnik@dartmouth.edu, or Topalova at PTopalova@imf.org. The views expressed in this paper are those of
the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its
management.

2
1. Introduction
New intermediate inputs play a central role in many trade and growth models. These
models predict that firms benefit from international trade through their increased access to
previously unavailable inputs, and this process generates static gains from trade. Access to these
new imported inputs in turn enables firms to expand their domestic product scope through the
introduction of new varieties which generates dynamic gains from trade. Despite the prominence
of these models, we have surprisingly little evidence to date on the relevance of the underlying
microeconomic mechanisms.
In this paper we take a step towards bridging the gap between theory and evidence by
examining the relationship between new imported inputs and the introduction of new products by
domestic firms in a large and fast growing developing economy: India. During the 1990’s, India
experienced an explosion in the number of products manufactured by Indian firms, and these new
products accounted for a quarter of India’s manufacturing growth (Goldberg, Khandelwal, Pavcnik
and Topalova, henceforth GKPT, forthcoming). During the same period, India also experienced a
surge in imported inputs, with more than two-thirds of the intermediate import growth occurring in
new varieties. The goal of this paper is to determine if the increase in Indian firms’ access to new
imported inputs can explain the introduction of new products in the domestic economy by these
firms.
One of the challenges in addressing this question is the potential reverse causality between
imports of inputs and new domestic products. For instance, firms may decide to introduce new
products for reasons unrelated to international trade. Once the manufacturing of such products
begins, the demand for imported inputs, both existing and new varieties, may increase. This would
lead to a classic reverse causality problem: the growth of domestic products could lead to the
import of new varieties and not vice versa. To identify the relationship between changes in imports
of intermediates and introduction of new products by domestic firms, we exploit the particular
nature of India’s trade reform. The reform reduced input tariffs differentially across sectors and was
not subject to the usual political economy pressures because the reform was unanticipated by
Indian firms.
Our analysis proceeds in two steps. We first offer strong reduced-form evidence that
declines in input tariffs resulted in an expansion of firms’ product scope: industries that experienced
the largest declines in input tariffs contributed relatively more to the introduction of new products

3
by domestic firms.
2
The relationship is also economically significant: lower input tariffs account on
average for 31 percent of the observed increase in firms' product scope over this period. Moreover,
the relationship is robust to specifications that control for pre-existing industry- and firm-specific
trends. We also find that lower input tariffs improved the performance of firms in other dimensions
including output, TFP and research and development (R&D) activity that are consistent with the link
between trade and growth.
In order to investigate the channels through which input tariff liberalization affected
domestic product growth in India, we then impose additional structure guided by the methods of
Feenstra (1994) and Broda and Weinstein (2006) and use India’s Input-Output (IO) Table to
construct exact input price indices for each sector. The exact input price index is composed of two
parts: a part that captures changes in prices of existing inputs and a part that quantifies the impact
of new imported varieties on the exact price index. Thus, we can separate the changes in the exact
input price indices faced by firms into a “price” and “variety” channel. This methodology reveals
substantial gains from trade through access to new imported input varieties: accounting for new
imported varieties lowers the import price index for intermediate goods on average by an
additional 4.7 percent per year relative to conventional gains through lower prices of existing
imports.
We relate the two components of the input price indices to changes in firm product scope.
The results suggest an important role for the extensive margin of imported inputs. Greater access to
imported varieties increases firm scope. This relationship is robust to an instrumental variable
strategy that accounts for the potential endogeneity of input price indices using input tariffs and
proximity of India's trading partners as instruments. Hence, we conclude that input tariff
liberalization contributed to domestic product growth not simply by making available imported
inputs cheaper, but, more importantly, by relaxing technological constraints facing such producers
via access to new imported input varieties that were unavailable prior to the liberalization.
3
2
Recent theoretical work by Bernard, Redding and Schott (2006), Eckel and Neary (forthcoming) and Nocke and
Yeaple (2006) shows that trade liberalizations should lead firms to rationalize their product scope. These
theoretical models focus on the role of final goods and tariffs on output, while the analysis of this paper focuses on
input tariffs and the role of intermediates.
3
The importance of increased access to imported inputs has been noted by Indian policy makers. In a recent
speech, the managing director of the Indian Reserve Bank Rakesh Mohan argued that “trade liberalization and
tariff reforms have provided increased access to Indian companies to the best inputs available globally at almost
world prices” (Mohan 2008).

4
These findings relate to two distinct, yet related, literatures. First, endogenous growth
models, such as the ones developed by Romer (1987, 1990) and Rivera-Batiz and Romer (1991),
emphasize the static and dynamic gains arising from the import of new varieties. Not only do such
varieties lead to productivity gains in the short and medium run, the resulting growth fosters the
creation of new domestic varieties that further contribute to growth. The first source of (static)
gains has been addressed in the empirical literature before. Existing studies document a large
expansion in new imported varieties [Feenstra (1994), Broda and Weinstein (2006), Arkolakis,
Demidova, Klenow and Rodriguez-Clare (2008), Klenow and Rodriguez-Clare (1997)], which,
depending on the overall importance of new imported varieties in the total volume of trade, can
generate substantial gains from trade [see, for example, Feenstra (1994) and Broda and Weinstein
(2006)].
4
Our evidence points to large static gains from trade because of increased access to
imported inputs.
The second (dynamic) source of gains from trade has been empirically elusive, partly
because data on the introduction of domestic varieties produced in each country have been difficult
to obtain.
5
The two studies that are closest to ours [Broda, Greenfield and Weinstein (2006) and
Feenstra, Madani, Yang, and Liang (1999)] resort to export data to overcome this difficulty. They
use the fraction of the economy devoted to exports and industry-specific measures of export
varieties as proxies for domestic R&D and domestic variety creation, respectively. The advantage of
our data is that we directly observe the creation of new varieties by domestic firms. This enables us
to link the creation of new domestic varieties to changes in imported inputs. In our framework,
trade encourages creation of new domestic varieties because Indian trade liberalization significantly
reduces tariffs on imported inputs. This leads to imports of new varieties of intermediate products,
which in turn enables the creation of new domestic varieties. Hence, new imported varieties of
intermediate products go hand-in-hand in our context with new varieties of domestic products.
Our study also relates to the literature on the effects of trade liberalization on total factor
productivity. Several theoretical papers have emphasized the importance of intermediate inputs for
productivity growth [e.g., Ethier (1979, 1982), Markusen (1989), Romer (1987, 1990), Grossman and
Helpman (1991)]. Empirically, most recent studies have found imports of intermediates or declines
4
Klenow and Rodriguez-Clare (1997) and Arkolakis, Demidova, Klenow and Rodriguez-Clare (2008) find small
variety gains following the Costa-Rican trade liberalization, which they attribute to the fact that the new varieties
were imported in small quantities, thus contributing little to welfare.
5
Brambilla (2006) is an exception.

Frequently asked questions

Q1. What are the contributions mentioned in the paper "Imported intermediate inputs and domestic product growth: evidence from india by pinelopi goldberg, princeton university" ?

The authors use detailed trade and firmlevel data from a large developing economy—India—to investigate the relationship between declines in trade costs, the imports of intermediate inputs and domestic firm product scope. Moreover, the authors find that lower input tariffs account on average for 31 percent of the new products introduced by domestic firms, which implies potentially large dynamic gains from trade. Hence, their findings suggest that an important consequence of the input tariff liberalization was to relax technological constraints through firms ’ access to new imported inputs that were unavailable prior to the liberalization. 

Q2. What future works have the authors mentioned in the paper "Imported intermediate inputs and domestic product growth: evidence from india by pinelopi goldberg, princeton university" ?

More detailed data would enable us, for example, to study the determinants and consequences of differential adoption of imported inputs by Indian firms, although such a study would need to address the endogeneity of this differential adoption of imported inputs by firms – the trade policy changes the authors exploit as a source of identification do not vary by firm. In future work the authors plan to further explore the contribution of these new products to TFP by exploiting product-level information on prices and sales available in their data. While the authors do not concentrate on aggregate growth, the fact that the creation of new domestic products accounted for nearly 25 percent of total Indian manufacturing output growth during their sample period suggests that the implications of access to new imported intermediate products for growth are potentially important. This will allow us to ultimately provide a direct estimate of the dynamic gains from trade. 

Q3. What is the controversial component of the identification strategy?

Perhaps the most controversial component of this identification strategy is that the unobservable components in (19) include total factor productivity since there is a evidence that trade liberalizations lead to productivity improvements. 

Q4. What is the effect of tariffs on the marginal cost of production for Indian firms?

production process by domestic firms, the observed declines in unit values of existing products will lower the marginal cost of production for Indian firms. 

Q5. What is the main argument for a rationalization of output tariffs?

One would expect elimination of x-inefficiency to be driven by pro-competitive output tariffs, rather than changes in input tariffs. 

Q6. How much of the input variety index declined during the period of their analysis?

During the period of their analysis, input tariffs declined on average by 24 percentage points, andfrom column 2, the decline in input tariffs led to a .25% decline in input variety index on average. 

Q7. What is the coefficient on the input variety index in column 2?

The coefficient on the input variety index in column 2 is negative and statistically significant suggesting that an increase in input variety (captured by a lower index number) is associated with an expansion of firm scope. 

Q8. What is the significance of the importation of new intermediate products for growth?

While the authors do not concentrate on aggregate growth, the fact that the creation of new domestic products accounted for nearly 25 percent of total Indian manufacturing output growth during their sample period suggests that the implications of access to new imported intermediate products for growth are potentially important. 

Q9. How does the relationship between input tariffs and product scope in India differ from other countries?

The relationship is also economically significant: lower input tariffs account on average for 31 percent of the observed increase in firms' product scope over this period.