In quality we trust: Dynamic patterns of quality upgrading in difficult markets

In this paper, I analyze how contract enforcement shapes firms' choice of product quality in export destination markets. Among the numerous hurdles creating frictions in international trade is insecurity of international exchanges. There exists an extensive documentation of the role of uncertainty in markets characterized by weak institutional quality on international trade (Anderson and Marcouiller, 2002; Dollar and Kraay, 2003; Levchenko, 2007). These studies have shown that firms facing these types of uncertainty revert to other forms of insurance to cope with it, such as vertical integration and relational contracting (Baker, Gibbons, and Murphy, 2002; Atkin and Khandelwal, 2020). The latter relies on the future value of trade between two partners as a disciplinary tool to prevent opportunistic behaviour. As a result, producers in successful partnerships increase their exports over time (Rauch and Watson, 2003; Arkolakis, 2010; Eaton et al., 2021; Fernandes and Tang, 2015; Allen, 2014).

In contrast to the literature examining the evolution of export values across destinations and time I investigate differences in quality of exported products. The literature finds ample evidence on quality sorting across destinations due to heterogeneities across firms overcoming fixed costs of exporting that vary by destination (Bastos and Silva, 2010). More specifically, they find that larger, more productive firms produce higher quality products at higher prices and can overcome fixed costs of exporting such as distance. Here, quality differences are exogenously determined via productivity differences.

I treat quality differentiation as an active choice made by firms that face uncertainties in international markets. These uncertainties can be related to opportunistic behaviour of international buyers (“take-the-goods-and-run” strategy a la Araujo, Mion, and Ornelas, 2016; Brugues, 2022) or immitation. In an environment characterized by weak contract enforcement, informational frictions and uncertainty prevent firms from exporting their highly differentiated, high quality products to these markets. Only as export relationships age, trust grows and firms begin providing their more valuable products to their partners. I develop a theoretical model of trade that allows for quality choice to jointly explain the evolution of firm growth rates and export prices over the life cycle of an export relationship. To capture the conditional age dependence of a partnership I consider a model of learning based on Araujo et al. (2016). Similar to Flach and Unger (2022) I explain product quality patterns by introducing output quality choice and quality investment costs as in Sutton (2007) and/or Kugler and Vorhoogen (2012). Using a basic Bayesian learning mechanism I introduce trust and learning about partner firms that build reputations over time to overcome the problems created by weak enforcement of international contracts. The learning process between exporting firms and foreign buyers lies at the heart of my model. Exporters can quality-discriminate across buyers and time, and the buyer can act opportunistically and simply take the goods and escape after the first transaction. Without access to external enforcement, the exporter uses the value of the relationship itself to discipline the buyer’s behavior, i.e. the expected increase in quality as the export relationship ages. Exporters learn about the reliability of their trade partners through repeated interactions. Weak institutions offer greater scope for opportunistic behavior but loose power as relationships persist.

I test these predictions studying a panel of German exporting firms from 2010 to 2019. I find that exporters start with higher quality products in destination markets that are characterized by better contracting institutions. However, as export partnerships grow old, the growth in quality of exported products decreases with the quality of the destination country's institutions. The effect on both initial quality and subsequent growth is dampened for firms showing a higher degree of export experience.

Keywords: international trade, institutions, quality, survival, Germany

JEL-Classification: F10, F12, L14