1. Introduction

The existing literature has largely established superior performance of exporters when compared to non-exporters (Bernard et al., 1995) . This has led to a reorientation of policy-makers and international organizations towards export-promotion policies in order to increase domestic growth. It is important to disaggregate the correlation between exporting and productivity in order to understand the underlying causal mechanism at the micro-level. Understanding the causation channel of higher productivity of exporters can direct policy formulation to achieve the desired impact. Robert and Tybout (1997) demonstrate that sunk costs, plant characteristics (observed or unobserved) and macroeconomic conditions significantly affect firm�s export decision.

This paper explains this causation through the role of sunk costs of exporting i.e. learning to export effect. Sunk costs are the fixed and irrecoverable costs that firms must incur in order to enter and produce in the market (Sutton, 1991). Sunk costs of exporting are expected to exist since in order to enter the export markets, firms need to incur information costs to learn about foreign markets (the demand sources, product standards, prices, custom rules), obtain export licenses and establish transportation, shipping and distribution networks (Robert & Tybout, 1997). The sunk costs create a wedge between incumbent and potential entrant�s total costs equal to the sunk cost. Firms with superior productivity self-select into the export markets because they can profitably incur sunk costs of exporting. In order to operate in export markets, entrants must profitably overcome sunk costs while incumbents must not make losses. Thus, the entry and exit threshold differs. A hysteresis band of productivities is created equaling the difference between cutoff productivity for exit and entry. Sunk cost leads to hysteresis effect i.e. a shadow cast of history on future. It acts as a barrier to entry and its reduction can aid entry of firms that can profitably export in the foreign markets. A temporary policy change can permanently alter the market structure by enabling potential entrants to recover sunk costs. However, uncertainty about the policy change can sever the effectiveness of these policies (Baldwin, 1989).

The following section provides evidence consistent with the existence of sunk costs of exporting and the effectiveness of temporary export promotion policy from a natural experiment created in Indian steel industry between 1998-2007, which has been used in Bown and Porto (2010). A temporary incentive enabled profitable potential entrants to incur sunk costs and enter the market, and they did not exit when the incentives were removed.


2. Evidence on Sunk Costs of Exporting

Sunk costs of exporting exist because firms need to incur information costs to know about the foreign market and to establish transportation, shipping and distribution networks. Evidence on existence of sunk costs in exporting can clearly be seen through the role of structural changes like technological advancements in communication and transportation. The technology revolution has drastically reduced the sunk costs of exporting. This has been the driving force for increase in the number of firms involved in exporting as well as the volume of goods being exported.

Temporary export promotion policy is a useful policy tool to eliminate inefficiencies in an industry due to sunk costs. Bernard et al. (2003) estimates show that 5% reduction in geographical barriers raised aggregate manufacturing labor productivity by 4.7% and killed 3.3% of U.S. plants. Sunk costs to enter export markets is higher than domestic markets, exposure to trade raises the sunk costs in an industry and forces firms with least productivity to exit the market. Such reallocation effects exist even in large economies like U.S. The evidence on existence of sunk costs of exporting can be established through the effect of export promotion policies. The incumbent firms in the industry have an edge over the potential entrants since they have already incurred the sunk costs. This can hold even if potential entrant is more productive than incumbent firms. Evidence of this can be seen through the analysis of Indian steel industry where export promotion incentives were temporarily introduced.

2.1 Natural Experiment Evidence: Indian Steel Industry

A natural experiment was created when the Indian Steel Industry was given combined preferential market access by similarly timed and constructed policies by major global steel importers U.S., EU and China in 2002, which were subsequently rescinded in early 2004 (Bown and Porto, 2010).

2.2 Empirical Evidence

2.2.1 Aggregate Export Trends

According to Bown and Porto (2010) estimation when in March 2002 Indian steel industry was exposed to an exogenous and unexpected preferential market access shock, there was a sharp surge in exports .This natural experiment is particularly interesting to seek evidence for sunk costs in exporting because it resulted in India�s steel exports increasing dramatically in a relatively short period of time from 2.98 million tonnes in 2001-02 to 4.96 million tonnes in 2002-03 and further to 5.5 million tonnes in 2004. Moreover, the expansion trend did not reverse after the measures were rescinded . Steel exports from India spurted 36.8% in 2002-03 while the total steel production showed a rise of 7.2% (Ministry of Steel, India). India�s exports to the U.S. increased dramatically- from $50 million in 2002 to $250 million in a single year. Interestingly, even after the measures were rescinded in 2004, Indian exports to the U.S. were on an upward trend i.e. $600 million in 2004 and $750 million by 2006 (Bown and Porto, 2010).

 

 

Figure-1 (Data Source � World Integrated Trade Solution)

 

Figure-2 (Data Source � Indiastat.com)

 

 

Figure (2) shows the export quantity trend. Total export quantity did fall in 2004-05 when the measures were rescinded but not to the 2001-02 aggregate export quantity. After the export-promoting incentives were rescinded, the incumbent�s exports fell back to the pre-existing level. However, they facilitated potential entrants to overcome sunk costs in exporting and enter the export market. Thus, the aggregate level did not fall back to the pre-policy level. In order to distinguish between entry and volume decisions of incumbents and entrants, let us look at the disaggregated trends.

 

2.2.2 Export trends at a disaggregated level

 

2.2.2.1 Incumbents Export Trends

 

The Indian steel industry can be divided into two types of producers: Integrated Producers comprising major players – Steel Authority of India Limited (SAIL), Rashtriya Ispat Nigam Limited (RINL), Tata Steel. Secondary Producers – the mini-steel plants with Essar Steel, IspatIndustries, Lloyds Steel, Jindal Steel being the major players. The integrated producers are the major incumbents in the market including JSW Steel. Since JSW Steel was formed from a merger in 2004-05 that coincides with the measures rescindment, I exclude it from the analysis. The three major integrated players were historic exporters and had already incurred the sunk costs of exporting.

 

Figure-3 Data Source � Indiastat.com (Compiled from statistics released by SAIL)

 

Figure (3) plots the exports of the three major players during 1995-2008. The time frame created by the natural experiment is analogous to the three-stage game: 1) Pre-2002 i.e. before the measures were introduced 2) 2002-2004 i.e. time period in which preferential treatment was granted 3) Post-2004 i.e. after the measures were rescinded. In 2002, following the introduction of preferences, there is a sharp increase in exports of all the three major incumbents i.e. SAIL, RINL, TISCO and the trend of surge in exports continued until 2004 when the measures were rescinded. Following 2004, the exports continued to fall and reached the pre-2002 export level by 2006 but continued to decline thereafter. Time-series export pattern of the three major players mirrors the policy change; there is a transient effect of export incentives on the incumbent firms.

 

2.2.2.2 Entrants Export Trends

The sustained export expansion after the policy rescindment can be explained by the constantly rising trend of secondary producers� total exports as opposed to the big three exporters. Figure (4) shows that there is a co-movement in the total steel exports and secondary producers� export trends which suggests that the continual expansion was mainly driven by the exports of secondary producers which is an aggregation of the export trends of mini-steel plants and the new entrants.

 

Figure-4(Data Source- Indiastat.com)

There is a structural break in the time series export pattern of secondary producers concurrent with the policy change in 2002. Structural break in time series regression occurs if the regressor number of firms is omitted (Baldwin, 1989). New entrants and their export trends can perhaps explain the sustained expansion of secondary producer�s exports after the policy rescindment. Figure (5) depicts the export trend of four new entrants that entered the export market in 2002 following the introduction of preferences but did not exit when they were rescinded. Analogous to secondary producers the exports of these new entrants have been continuously increasing since the policy introduction. Since these firms did not exit after policy rescindment, this indicates that they could profitably export without the policy aid but could not recover the sunk costs to export. A temporary incentive can enable potential entrants to recover sunk costs of entering the export market. Sunk costs act as a barrier to entry and temporary preferential advantage can facilitate new firms� entry and expansion into the export market. The exports of the new entrant have been increasing since the introduction of preferences and have continued to increase even after the preferences were rescinded while the exports of the big three integrated producers have been falling. This suggests that the new entrants are more efficient than incumbents so their export market share has been rising compared to incumbents.

 

Figure-5(1. Vardhman, VLS Wires & RL Steel export trends compiled from Prowess, CMIE 2. Bhushan export trend compiled from Bhushan steel website)

The temporary export-promoting policy alter the market structure permanently by enabling potential entrants attain economies of scale to overcome sunk costs of exporting. Thus, it increases the number of active firms, alters their relative market shares and possibly facilitates efficiency gains if there exist potential entrants that have superior productivity than incumbents and could enter due to this temporary incentive. The key effect of the policy change is that it aids the entry of potential entrants with higher productivity levels which previously could not enter. This leads to efficiency gains, as exports will be made at a lower unit cost in the market. This is in conjecture with Melitz & Bertrand et al (2003) finding that exposure to trade reallocates market shares towards firms with superior productivity and generates aggregate industry productivity growth that contributes to welfare gains and growth and that the effect of trade incentives does not depend on firm heterogeneity in the absence of sunk costs. Similarly, a negative shock can shrink the no-exit range and make incumbent firms exit. �Hysteresis differs from irreversibility since the system could be restored to its period t state by a corrective shock.� (Baldwin, 1989, pp.15)

–Manpreet Kaur Juneja

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i. The evidence on superior productivity of the exporting firms as opposed to non- exporters has been demonstrated in many studies in the literature (see: Jensen and Wagner (1997), Aw and Hwang (1995), Aw et al. (1997, 2000), , Clerides et al. (1998)) (Delgado, Farinas & Ruano, 2002, pp398).

 

ii. Existing exporters, entrants and product switching by historic exporters, drove the export expansion.

iii.Data source: IndiaStat

iv. Jindal Iron and Steel Co. Ltd. (JISCO) and Jindal Vijayanagar Steel Ltd. (JVSL) merged and formed JSW Steel.