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.
