Global Mad Men
To understand why firms succeed in international trade, look not to prices, but to advertising and the creation of demand
Published June 13, 2016
Company growth is at the core of economic vitality. International trade is also central. The intersection of the two dynamics is the focus of “How Exporters Grow” (SR 524)1 by Doireann Fitzgerald, a senior research economist at the Minneapolis Fed, along with Stefanie Haller at University College Dublin and Yaniv Yedid-Levi at the University of British Columbia. The economists discover that product prices—so fundamental to economics—do not play a key role in explaining why a firm may have rapid export growth in some markets but not in others.
Instead, they find, one must look to demand—and specifically the effort a company puts into generating demand through advertising and marketing—to understand the growth of exporters. “Demand plays a quantitatively important role in explaining how exporters grow in a market,” the economists conclude, and “nonprice actions such as marketing and advertising play a key role in expanding demand.”
To reach those conclusions, the economists first explore the growth dynamics of exporters with a careful analysis of Irish data and then use these empirical facts to shape a model to illuminate the mechanisms that explain export success.
The empirical section of their research draws on two data sources, the Irish Census of Industrial Production (CIP) and Irish customs records. The CIP lists companies with three or more employees in the manufacturing, mining and utilities sectors. Irish customs data provide quantities and value (in euros) of specified products exported to specified markets between 1996 and 2014.2 By carefully matching product prices, quantities, Irish firms and national markets over nearly two decades, the economists develop a detailed landscape of how exporters grow (or fail to).
The data show that, like most small European countries engaged in international trade, a high percentage of Irish companies (44 percent) export to several nations (6.6 countries, on average). Beyond that, the Irish trade picture is broadly similar to those of large developed countries and developing countries, suggesting that the research findings from this paper may apply to those nations as well. The additional fact of high “churn”—about half of Irish exporters change the number of markets they sell to every year—is what allows the economists to analyze export market tenure and the factors behind it.
Several key facts emerge:
- Export quantities grow dramatically in the first five years of “successful export spells” (defined as seven or more consecutive years of a given company exporting to a specific country).
- Within those successful spells, there are no significant price dynamics.
- Higher initial export quantities predict longer export spells.
- Initial prices do not predict export spell length.
“In sum, there are very striking dynamics of quantities with respect to market tenure,” write Fitzgerald, Haller and Yedid-Levi, “but no … significant dynamics in prices” (emphasis added).
Mechanisms at work
To understand why quantities, not prices, are crucial to explaining export success, and to more generally explore dynamics of firms in international markets, the economists then build a model with two key elements: (1) spending on marketing and advertising to develop customer base within a market, and (2) learning over time about each market’s distinctive demand characteristics.3
Each of these elements is crucial to the model. Developing a customer base with nonprice tools is important since the data show that export quantities increase even though prices don’t change. And learning about demand over time in each market is essential to explaining “the large number of export spells that start small and last only one period,” they write, “as well as the fact that the exit hazard initially declines rapidly and eventually flattens out.”
To explain why the data show a gradual convergence of exports, rather than jumping quickly to their long-run level, the model also specifies that building a customer base involves a cost to the firm—an expense the firm won’t undertake without due consideration of potential for additional sales. “We allow for both costs of adjustment and learning about demand in our model.”
Once the model is built, the economists compare its results with their empirical findings. The fit is remarkable. “The estimated model matches all of the key facts in the data,” they report. The relationship between initial quantity sold and eventual duration of an export spell is predicted almost perfectly by the model. Trends in quantity growth over time tightly match the model’s predictions. The model also closely forecasts the declining probability of market exit.
The economists’ model, in sum, closely matches the empirical realities of initial and eventual export quantities, as well as duration in export markets. The research thus provides strong evidence of the quantitative importance of demand-based factors in explaining firm dynamics and on the mechanisms behind this—specifically adjusting customer base and slow learning about idiosyncratic demand—both key elements to success in export markets.
1 Also Working Paper 21935, National Bureau of Economic Research.
2 For baseline analysis, the staff report restricts attention to the period 1996-2009 for which both CIP and customs data are well matched.
3 In explaining exporter growth, the economists focus on demand, not supply, because factors that determine a firm’s overall ability to supply markets—such as firm productivity and financial constraints—affect all markets in which that firm sells, whereas their data and model examine differences among national markets. “Supply-side factors … that affect all markets equally cannot explain the dynamics we document.”