This paper presents an analysis of the effect of China’s entry into the WTO on the quality choices of Chinese exporters in terms of their outputs and their inputs. Using highly disaggregated firm-level data, we show that the quality upgrading made possible by China’s tariff reductions was concentrated in the least productive Chinese exporters. These firms, which had been laggards in terms of quality prior to the tariff reduction, were the most aggressive in increasing the quality of their exports and their inputs and in redirecting their exports toward high income markets where demand for high quality goods is strong. Our empirical results are consistent with a simple model featuring scale effect and non-Hicks’ neutral productivity that disproportionately affects the efficiency with which firms use intermediate inputs. This latter feature does not appear in workhorse models of firm heterogeneity and endogenous quality choice which provide a distorted view of the impact of trade liberalization on quality upgrading.

Introduction

Firms from developing countries historically have failed to break into developed country markets. Much of their difficulties stem from an inability to produce at sufficiently low cost the high quality goods that these markets demand. One of the reasons proposed for the competitive disadvantage of developing country firms is that government efforts to protect domestic intermediate input producers artificially raise the cost of the high quality intermediate inputs necessary to produce high quality goods. This paper presents an analysis of the effect of China’s entry into the WTO on the quality of Chinese exports. We use highly disaggregated firm-product-level data and the shock of China’s entry into the WTO to trace through in detail the mechanisms through which trade liberalization contributes to quality upgrading by Chinese firms. We find that the chief beneficiaries of liberalized intermediate input tariffs are not the initially most productive firms but are instead the less productive firms that are operating in industries in which the scope for quality variation is the most pronounced. It is these lower productivity firms that are most likely to upgrade the quality of their exports, increase the quality of their imported intermediates, and upgrade their workforces. In so doing, these firms are better able to break into markets with high demand for product quality and reduce the gap in their quality performance relative to initially more productive firms. China’s entry into the WTO in 2001 provides an excellent opportunity to identify the causal effect of trade liberalization on quality upgrading. First, the tariff reductions imposed on China, viewed as unilateral trade liberalization, were largely outside of China’s control.2 Second, China’s imports are mostly dominated by intermediate inputs with tiny share of final consumption goods, and so the impact of import tariff reductions is largely operating on imported intermediate inputs.3 Third, the effect of tariff reductions on the cost of Chinese production is highly heterogeneous across industries and across firms within industries. We carefully calculate total factor productivity of Chinese firms just prior to the trade liberalization and provide the following stylized facts: low TFP exporters were most likely (i) to increase their export prices to foreign destinations, and (ii) to increase the wages they pay their workers and the prices they pay for their inputs. Importantly, these outcomes were only present in those industries in which quality heterogeneity across products is high. Moreover, the evidence at the extensive margin shows that low TFP exporters were most likely to expand into high income country markets where demand for high quality goods is strong.