Trade and Investment Under Policy Uncertainty: Theory and Firm Evidence

72 Pages Posted: 1 Mar 2012

See all articles by Kyle Handley

Kyle Handley

University of Michigan, Stephen M. Ross School of Business

Nuno Limão

University of Maryland - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: February 2012

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

JEL Classification: D8, D92, E22, F02, F1, F5, H32, O24

Suggested Citation

Handley, Kyle and Limão, Nuno, Trade and Investment Under Policy Uncertainty: Theory and Firm Evidence (February 2012). CEPR Discussion Paper No. DP8798. Available at SSRN: https://ssrn.com/abstract=2013769

Kyle Handley (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Nuno Limão

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States
301-405-7842 (Phone)
301-405 3542 (Fax)

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