imported inputs in indonesia's product development

ERIA-DP-2015-55

ERIA Discussion Paper Series

Imported Inputs in Indonesia’s

Product Development

Lili Yan ING*

Economic Research Institute for ASEAN and East Asia and

University of Indonesia

Chandra Tri PUTRA

The Australian National University

August 2015

Abstract: The paper argues that reductions in input tariffs will increase value added

via product variety and quality. Using Indonesia’s firm and product level data from

2000 to 2010, the findings show that a reduction of one percent in input tariffs will

increase value added by 0.2 percent, not only via its interaction with importing firms,

but also with exporting firms that use imported products as their inputs. A one-

percent reduction in input tariffs will increase product variety and quality by 3.5

percent and 1.5 percent, respectively. Exporting firms tend to have a higher value

added than the average of all firms, and they also tend to have increased variety and

higher quality of products. Foreign firms also tend to have a relatively higher value

added than the general average, but they do not necessarily have increased product

variety and higher quality.

Keywords: Indonesia, tariff, imported input, product variety, product quality

JEL Classification: F12, F13, L16, O14, O19, O24

* Lili Yan Ing thanks Statistics Indonesia for providing the data, particularly Titi Kanti Lestari,

Emil Azman Sulthani, Sagap Kalipto, Rifa Rufiadi, Tri Supriyati, and Rina Dwi Sulastri for their

kind cooperation in providing export and import data by firm and product level. The authors thank

Xiao Jiang, Fukunari Kimura, Miaojie Yu, and Hal Hill for their comments on earlier draft.

2

1. Introduction

Trade evolves. Production is sliced. Much of production is based in production

networks. Imports are largely used as inputs for exports. Many countries are engaged

directly and indirectly in producing final products. The development of global

production chains, with an increased use of imported inputs, caused a reduction of the

domestic value added content for each unit of manufacturing production and exports.

This was quite feasible in the major euro area economies from 2000 to 2007 at a

different pace amongst the three countries, with a stronger reduction for Italy than for

Germany and France (Amador, et al, 2015). This phenomenon was also feasible in a

number of developing countries.

This paper aims to analyse the roles of imported inputs on value added, product

variety, and exported product quality of one of the growing developing countries,

Indonesia.1 The reasons for choosing Indonesia as an exercise object are twofold. First,

Indonesia is one of the seven gainers in the world of manufacturing products, placing

her after China, Korea, and India. Second, there has been a growing concern of

increasing imports in developing countries including Indonesia.

It is illustrated that the winners in the manufacturing sector over the last three

decades apparently have been developing countries that industrialised by joining,

rather than building, production networks which are part of the production networks

of the United States and Germany (i.e. Poland and Turkey) and part of the production

networks of Japan (i.e. China, Korea, Indonesia, and Thailand) as shown in Figure 1.

India is an exception (Baldwin, 2013).

Indonesia’s manufacturing sector was amongst seven gainers in the share of the

world’s manufactured products over the past three decades, even though relatively

small, in terms of contribution to the world’s value added in manufacturing in which

Indonesia’s contribution increased from 0.1 percent in 1970 to 1.8 percent in 2011.

1 The discussion on variety and quality of a country’s exports is in Hummels and Klenow (2005).

3

Figure 1: Indonesia is One of the Top–7 Gainers in the Share of Manufacturing

Value Added to the World (1970–2012)

Source: Authors’ calculations based on UNSTAT [accessed in March 2013], reconstruction of

Baldwin, 2013.

Based on trade in value added in exports (OECD), Figure 2 shows that the ratio of

domestic value added embodied in Indonesia’s total exports increased from 81 percent

in 2000 to 86 percent in 2009.2

This was relatively higher than the average of five Southeast Asian countries

(Malaysia, the Philippines, Singapore, Thailand, and Viet Nam), which increased from

57 to 59 percent over the same period. The main reason for a relatively high domestic

value content in total exports of Indonesia, particularly in Agriculture and Mining,

which had an average of more than 95 percent from 2000 to 2009, could be relatively

natural, in that Indonesia is a resource-abundant country. Nonetheless, domestic value

contents were also quite visible in Indonesia’s exports of manufactured products. The

ratio of that domestic value added to the value of exports of manufactured products

was 76 percent in 2000 and increased to 82 percent in 2009. It was relatively lower

than the ratio of domestic value added to total exports, but was still relatively higher

2 The ratio of domestic value added to exports is measured by the ratio of the value contributed

by domestic factors of production to the value of total exports.

0%

5%

10%

15%

20%

25%

1970 1975 1980 1985 1990 1995 2000 2005 2010

Canada ChinaFrance GermanyItaly JapanUnited Kingdom

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

1970 1975 1980 1985 1990 1995 2000 2005 2010

India Indonesia Poland

Korea Thailand Turkey

4

than the average of the other Southeast Asian countries at 50 percent, which increased

to 53 percent over the same period

Figure 2: The Ratio of Domestic Value Added and Foreign Value Added

to Total Exports (2009)

Indonesia ASEAN–5 (Malaysia, Philippines, Singapore,

Thailand, and Viet Nam)

Source: Authors’ calculations based on OECD Trade in Value Added, 2013 [accessed in November

2013].

In fact, it is still relatively higher compared with similarly resource-abundant

countries like Malaysia, China, and India whose ratios of domestic value added to

exports of manufactured products were 55 percent, 65 percent, and 71 percent,

respectively, in 2009. It is likewise higher than the developing countries’ average of

69 percent in the same period.

The relatively high domestic contents were also quite visible in most lines of

exports of manufactured products. Other than in natural resource-intensive

manufacturing industries (for example, leather and footwear, wood and paper, and

basic metals), domestic contents contributed around 85 percent, 61 percent, 73 percent,

and 83 percent to exports of manufactured products in chemical, machinery,

electronics, and transport, respectively, in 2009.

Apparently, domestic contents were quite visible in most lines of Indonesia’s

exports of manufactured products; however, if we examine their composition,

0 20 40 60 80 100

Agriculture

Mining

Food and beverages

Textiles, clothing and…

Wood and paper

Chemicals

Basic metals

Machinery

Electrical equipment

Transport equipment

Manufacturing nec

Domestic goods Domestic services

Foreign goods Foreign services

0 20 40 60 80 100

Agriculture

Mining

Food and beverages

Textiles, clothing and footwear

Wood and paper

Chemicals

Basic metals

Machinery

Electrical equipment

Transport equipment

Manufacturing nec

Domestic goods Domestic services

Foreign goods Foreign services

5

Indonesia’s exports are still relatively reliant on agriculture and natural

resourceintensive products. The ratio of the value of exports of manufactured goods

to total value of exports decreased from 49 percent in 2000 to 34 percent in 2010.

Compared with other large emerging countries such as China and Brazil, the ratio of

Indonesia’s exports in machinery and parts to total exports was lower at about 15

percent compared with 20 percent for Brazil and 23 percent for China in 2011 (Figure

3).

Figure 3: Indonesia in Production Network: Indonesia’s Exports of Machinery

and Parts were Lower than those of its Large Emerging Peers

Source: Authors’ calculations based on UNCOMTRADE, using SITC Rev 3–5 digit [accessed in

April 2014].

This leads us to a question if there is correlation between relatively high domestic

contents and composition of exports: What are the roles of imported inputs in value

added? What are the roles of imported inputs in product variety and quality?

Section 2 presents a theoretical framework. Section 3 describes the estimation

strategy, data, and data sources. Section 4 presents empirical results. Section 5

concludes.

20%

23%

15%

12%

0% 10% 20% 30% 40%

Brazil

China

Indonesia

India

Exports, 2011

Machinery Machinery parts and components

21%

19%

25%

20%

0% 10% 20% 30% 40%

Brazil

China

Indonesia

India

Imports, 2011

Machinery Machinery parts and components

6

2. Theoretical Framework

A number of key studies analyse how trade affects overall productivity, starting

from how exposure to trade leads to increasing inter-firm reallocations toward more

productive firms (Melitz, 2003), how trade liberalisation affects plant productivity

(Fernandes, 2003), how trade liberalisation fosters productivity growth within and

across firms, and in aggregate by inducing firms to produce only marginally productive

products and forcing the lowest-productivity firms to exit (Bernard et al., 2006), how

tariff reductions on intermediate inputs affect productivity more than tariff reductions

on final goods (Amiti and Konings, 2007), to how tariff reductions on imported inputs

affect product diversification and product quality (Goldberg et al., 2008).

We expect there are at least two mechanisms through which imported inputs could

affect value added through product development. Imported inputs are substitutes or

complimentary for domestic inputs and thus may have effects on prices as well as

quality of inputs. For a given quality of inputs, firms always try to find inputs at the

lowest prices. First, imported inputs can act as a catalyst to expand product

diversification. Second, imported inputs may increase product quality.

Set up

Consumers have non-homothetic preferences of product variety, and firms could

enter to produce new varieties of goods if the firm would like to invest a certain amount

of fixed costs of innovation that is independent of the number of goods produced and

variable cost of a new variety of goods. In producing a new variety of goods, the firms

have flexibility to use domestic and/or imported inputs. Our set up is based on a model

of optimal choices of product scope for multiproduct firms developed by Feenstra and

Ma (2008), and the use of domestic and imported inputs is introduced.

2.1 Consumption

Utility is derived from consuming homogenous and heterogeneous goods. As in

Feenstra and Ma (2008), and Fajgelbaoum et al. (2011), individuals have non-

homothetic preferences over heterogeneous goods with constant elasticity of

substitution.

7

𝑈 = 𝑦0 + 𝜌 ln(𝑄) with 𝜌 < 1 (1)

𝑦0 stands for homogeneous goods, and is normalised to 1. 𝑞 denotes quantity of

heterogeneous goods, and 𝑞(𝑖) is the quantity consumed of variety 𝑖, and 𝜂 > 1 is the

elasticity of substitution between heterogeneous good varieties, and the variety is

continuum 𝑖 ∈ [0, 𝑁]. 𝑄 is an index of horizontally heterogeneous goods.

𝑄 = [∫ 𝑞(𝑖)𝜂−1𝜂

𝑁

0

𝑑𝑖]

𝜂𝜂−1

with 𝜂 > 1

(2)

𝑅 is aggregate expenditure in this sector. The quantity of consumed goods of

variety, 𝑖, could be rewritten as a function of expenditure:

𝑞(𝑖) =𝑅

𝑃𝑄1−𝜂 𝑝𝑞(𝑖)

−𝜂 (3)

Given the quality of goods produced, each firm can choose the continuum of prices,

𝑝(𝑖). Suppose that each firm has the same marginal cost for all its varieties, 𝑝𝑗 =

𝑝(𝑖). The Price index can be written as:

𝑃𝑄 = (∑𝑁𝑗𝑝𝑞𝑗1−𝜂

𝐽

𝑗=1

)

11−𝜂

(4)

2.2. Production

Suppose there are factors of production, capital, labour, and material – 𝐾, 𝐿, and

𝑀. Each firm j, 𝑗 ∈ [1, 𝐽] uses the three factors in production. In equilibrium, labour

is in full employment, markets are clear, and firms earn zero profit.

2.2.1. Perfect competition

The homogenous goods are freely traded and produced by perfectly competitive

firms. The firms in the perfect competition market (𝑃𝐶) have the following costs and

profit functions:

8

𝑇𝐶𝑗𝑃𝐶 = 𝐹𝐶𝑗 + 𝑉𝐶𝑗 = 𝑐0𝑗 + 𝑐𝑗𝑦0𝑗 (5)

max(𝑝𝑗,𝑦0𝑗)≥0

Π𝑗𝑃𝐶 = 𝑦0𝑗 (𝑝𝑦𝑗

− 𝑐𝑗) − 𝑐0𝑗 (6)

The optimal choice of price 𝑝𝑦𝑗 is 𝑝𝑦𝑗

= 𝑐𝑗.

2.2.2. Profit function in monopolistic competition market

The heterogeneous goods are produced in a monopolistic competition (𝑀𝐶)

market.

𝑞𝑖 = 𝜑𝑖 (𝐿𝑖

𝜇−1

𝜇 + ∫ 𝑥𝑚𝑖

𝜇−1

𝜇 𝑑𝑚𝑖𝑀𝑖

0)

𝜇

𝜇−1

with > 1

(7)

𝜑 is cumulative productivity of labour and input material. 𝐿 is the number of unit

labour. 𝑚 is variety of input material, and 𝑚𝑖 is the number of varieties of input

material used in producing product 𝑖. 𝑀 is the number of input material varieties, 𝑀 ∈

[0,𝑀] and 𝑀𝑖 are the numbers of variety of input material used in producing product

𝑖. Let 𝑥 be quantity of input material and 𝑋𝑀 the quantity index of input material. 𝑥𝑚𝑖

is the quantity of input material 𝑚-th that is used in producing the 𝑖-th product and 𝑋𝑀𝑖

is the cumulative quantity index of all input material used in production of variety 𝑖.

𝜇 is the elasticity of substitution of factors of production (e.g. elasticity of substitution

between labour and material or amongst materials).

𝑋𝑀 = (∫ 𝑥𝑚

𝜇−1𝜇 𝑑𝑚

𝑀

0

)

𝜇𝜇−1

(8)

𝑝𝑚 stands for the price of material 𝑚 and 𝑝𝑚𝑖 stands for the price of material used

in production of variety 𝑖. 𝑃𝑀 is an index price of material and 𝑃𝑀𝑖 is a cumulative

index of the price of all input materials in production of variety 𝑖.

9

𝑃𝑀 = (∫ 𝑝𝑚1−𝜇

𝑑𝑚𝑀

0

)

11−𝜇

(9)

Firms may decide to produce a new product line (in the empirical work, it will be

defined as if the firm could produce a new product line at ISIC–9 digit). If the firms

have the ability to produce a new variety of goods at a certain level of quality that

requires them to spend on a fixed cost of innovation, 𝑘0, and marginal cost of new

varieties which is constant across varieties, 𝑘1. 𝑁𝑗 is the number of varieties produced

by firm j and a firm produces at least one variety of good, 𝑁𝑗 > 0.

The cost function:

𝑇𝐶𝑗𝑀𝐶 = 𝐹𝐶𝑗 + 𝑉𝐶𝑗 = 𝑐0𝑗 + 𝑐𝑗𝑞𝑗 + 𝑘0𝑗 + 𝑘1𝑗𝑞𝑗𝑁𝑗 (10)

The total production and cost functions could be written as follows.

𝑁𝑗𝑞𝑗 = 𝑁𝑗𝑞𝑖 = 𝑁𝑗𝜑𝑖 (𝐿𝑖

𝜇−1𝜇 + ∫ 𝑥𝑚𝑖

−1

𝑑𝑚𝑖

𝑀𝑖

0

)

𝜇𝜇−1

(11)

𝑁𝑗𝑐𝑗 = 𝑘0 + 𝑁𝑗 (𝑘1 + 𝑤𝐿𝑖 + ∫ 𝑝𝑚𝑖𝑥𝑚𝑖

𝑑𝑚𝑖

𝑀𝑖

0

) (12)

The profit function in the monopolistic competition market is as follows.

Max(𝑝𝑞𝑗

,𝑁𝑗)≥0Π𝑗

𝑀𝐶 = 𝑁𝑗𝑞𝑗 (𝑝𝑞𝑗− 𝛾𝑗) − 𝑘0 − 𝑘1𝑁𝑗 (13)

With 𝛾𝑗 as the marginal cost of labour and material and 𝑘1𝑗 as the marginal cost of new

variety that depends on additional intermediate inputs, both marginal cost of

production and that of new variety are constant across variety.

10

𝛾𝑗 =(𝑤1−𝜇 + 𝑃𝑀𝑖

1−𝜇(𝑚))

11−𝜇

𝜑𝑖

(14)

Marginal cost of new variety 𝛾1 depends on prices of materials, 𝑃𝑀. The prices of input

material depend on domestic input prices, 𝑝𝑚, and imported input prices which are

also affected by import tariffs,, 𝑃𝑀 = (𝑝𝑚, 𝑝𝑚∗ (𝑝𝑚

∗ , 𝜏)). In an input market, all firms

are price takers and thus do not have any power to determine prices on inputs.

Domestic and imported inputs are imperfect substitutes. As quality of inputs required

in their production is given, firms choose the lowest prices of inputs.

The optimal choice of the number of varieties as a function of output prices and

cumulative productivity of labour and input material could be written as follows.

𝑁𝑗 = [1 −𝛾𝑗

(𝑝𝑞𝑗− 𝛾𝑗) (𝜂 − 1)

] 𝛼𝜂−1𝑃𝑄

1−𝜂𝜂

𝜑𝑖

𝜂−1𝜂

With as 𝑝𝑞𝑗≥ 𝛾𝑗 , 𝑝𝑞𝑗

≥𝜂

(𝜂−1)𝛾𝑗

(15)

The prices of output depend on import tariffs,, 𝑝𝑞 = (𝑝𝑞 , 𝜏𝑞). The optimal choice of

price 𝑝𝑞𝑗 can obtained as follows.

𝑝𝑞𝑗= 𝛼𝑃𝑄

𝜂−1

𝜂 𝛾𝑗

1

𝜂 where 𝛼 ≡ [𝑅

𝑘1(𝜂−1)]

1

𝜂

(16)

Where 𝛼 is the share of expenditure to marginal cost of new varieties. The optimal

functions of profit , 𝑝𝑞𝑗 and 𝑁𝑗 are in Appendix.

11

3. Estimation Strategy and Data

3.1. Estimation Strategy

We will test estimate the impacts of output and input tariffs on output, 𝑞𝑗𝑡. Output

here will be measured by real value added per worker.

ln (𝑉𝐴𝑗𝑡) = 𝛽0 + 𝛽1𝐹𝑗𝑡 + 𝛽2𝜏𝑞𝑗𝑡 + 𝛽3𝜏𝑚𝑗𝑡 + 𝛼𝑗 + 𝛼𝑡 + 𝜀𝑗𝑡 (17)

𝛼𝑗 is a fixed effect for time-invariant firm characteristics, and 𝛼𝑡 is year-fixed

effect. 𝐹𝑗𝑡 is time-variant firm characteristics. 𝜏𝑞𝑗𝑡 is output tariff by ISIC–5 digit. 𝜏𝑚𝑗𝑡

is input tariff by ISIC–5 digit. As firms are price takers and do not have any power to

determine prices that could affect tariff, ∀𝑗 they face the same level of tariffs for the

same input.

We will also test two mechanisms through which imported inputs could affect

product development. First, imported inputs can act as a catalyst to expand product

diversification. 𝑁𝑗𝑡 is the number of variety of products produced by firm 𝑗 at time 𝑡.

ln (𝑁𝑗𝑡) = 𝛽0 + 𝛽1𝐹𝑗𝑡 + 𝛽2𝜏𝑞𝑗𝑡 + 𝛽3𝜏𝑚𝑗𝑡 + 𝛼𝑗 + 𝛼𝑡 + 𝜀𝑗𝑡 (18)

Second, imported inputs can increase product quality, which is represented by

prices of products. Suppose each firm has the same marginal cost for all its varieties,

so it will charge the same price for them. 𝑝𝑗𝑡 is the prices of products produced by firm

𝑗 at time 𝑡. The price is corresponding to unit value, which represents quality of

products.

ln (𝑝𝑗𝑡 ) = 𝛽0 + 𝛽1𝐹𝑗𝑡 + 𝛽2𝜏𝑞𝑗𝑡 + 𝛽3𝜏𝑚𝑗𝑡 + 𝛼𝑗 + 𝛼𝑡 + 𝜀𝑗𝑡 (19)

12

3.2.Data

The main data sources are Indonesia’s firm-level and product-level data, which

are based on Manufacturing Survey (Survey Industry) for medium and large size firms

with 20 or more employees. We merge the firm level and product level datasets. The

data contain information of firm characteristics, product varieties HS–9 digit, the

shares of products sold in domestic and export markets, the share of imported inputs,

and very rich firm characteristic variables. The data are from 2000 to 2010.

The data cover all registered manufacturing firms with around 20,000 firms

annually, which results in a total number of observations of 253,911. Of those

observations, 21,671 observed firms or 8.5 percent of the total sample are importing

as well as exporting firms at the same time (please note that in our sample we only

include manufacturing firms, and exporting and importing firms that are also

manufacturers, and exclude distributors).

Following Amiti and Konings (2007), and Goldberg et al. (2008), the input tariffs

are constructed as follows. Input tariffs are defined as 𝑞𝑡𝑚 = ∑ 𝑠𝑚𝑞𝜏𝑚𝑡𝑚 where 𝑠𝑚𝑞 is

the cost share of input 𝑚 in industry 𝑞. For an illustration, if the batik (garment)

industry spends 40 percent of total costs on cloth, 30 percent on batik colouring, 20

percent on wax, and 10 percent on other materials. We give weights of 40 percent, 30

percent, 20 percent and 10 percent to batik cloth tariff, batik colouring tariff, wax tariff,

and other materials tariff, respectively. Input tariffs are calculated as a weighted

average of the output tariffs using Indonesia’s input–output data for 2000, 2005, and

2009. The concordance of the HS–9 digit to ISIC–5 digit is provided by Statistics

Indonesia. Please note that the input tariffs are constructed at the industry level, not at

the firm level.

Value added is defined as the difference between the value of total outputs and the

value of total inputs. The real value added is constructed by deflating the value added

using a price deflator. The real value added per worker is the real value added divided

by the number of total workers.

A new variety in the empirical exercises is defined as a new variety at HS–9 digit.

A firm is defined to produce a new variety if it could produce a new good with a new

product code in the HS–9 digit classification. So the number of varieties of goods is

defined as the number of total varieties at HS–9 digit.

13

Product quality is approached by unit value of goods, which is constructed as the

value of total outputs divided by the total volume.

4. Empirical Results

Table 1 represents summary statistics of variables which consist of output tariff,

input tariff, log real value added per worker which stands for value added, log number

of goods which represents product quantity, log output prices which represents product

quality. The main firm characteristics are represented by their trading activities which

are determined by import and export shares, and by ownership.

Table 1: Summary Statistics

Variable

Observations Mean Standard

Deviation

Output tariff 253,911 0.081 0.046

Input tariff 253,911 0.065 0.017

Ln (real value added per worker) 253,911 4.709 1.264

Ln (number of goods) 253,911 0.479 0.650

Ln (output prices) 253,911 5.052 0.325

Import share 253,911 0.093 0.235

DM = 1 if import share > 0 253,911 0.254 0.435

Export share 253,911 0.127 0.295

DX = 1 if export share > 0 253,911 0.127 0.295

Foreign share 253,911 0.070 0.181

DFDI = 1 if foreign share 0.1 253,911 0.479 0.499

Table 2 presents the impacts of tariff reductions on value added. Column 1 shows

that output tariff reductions will increase value added by 0.02 percent. However, once

we include input tariffs, as illustrated in Column 2 and further estimations, it can be

seen that the impacts of output tariffs on value added are lower than the estimation

with output tariff alone, whilst a reduction of 1 percent in input tariff will raise value

added by as much as 0.2 percent.

Column 3 shows 1 percent of input tariff reduction will increase the value added

by 0.2 percent, which is a result of the combination of input tariffs and their interaction

with importing firms.

14

Columns 4 and 5 also show consistency in findings that a 1 percent of input tariff

reduction will increase value added by 0.2 percent. They show, on average, that a

reduction of 1 percent in input tariffs alone will increase value added by 0.1 percent.

The magnitude of the effect of tariff reductions on value added is amplified by the

interaction between importing firms enjoying the tariff reduction (0.07 percent) and

exporting firms using imported inputs for their exports (0.04 percent) which means

that a reduction of 1 percent in input tariff will increase value added by 0.2 percent.

One percent of tariff reductions also provide higher value added gains for importing

and exporting firms than for the average of all firms. Importing manufacturing firms

have about 1 percent higher value added, whilst exporting manufacturing firms will

have about 0.4 percent higher value added than the average of all firms.

The findings are consistent with those of Amiti and Konings (2007) over the

sample period from 1991 to 2001, but at a lower magnitude. The reasons are twofold.

First, the average input tariffs are lower, with an average of 6.5 percent, from 2000 to

2010 covered in this study compared with an average of 10.1 percent in their study.

Second, the marginal contribution of tariff reductions to value added is decreasing.

15

Table 2: The Impacts of Tariff Reductions on Value Added

Fixed Effect Estimation Results Dependent Variable: Value Added (ln [real value added per worker])

(1) (2) (3) (4) (5) (6)

Output tariff -

0.024***

-

0.017***

-

0.017***

0.016*** -0.016*** -0.017***

(0.006) (0.002) (0.002) (0.003) (0.003) (0.003)

Input tariff -

0.129***

-

0.108***

-0.105*** -0.098*** -0.116***

(0.021) (0.030) (0.282) (0.031) (0.025)

Input tariff x DM -0.065* -0.058* -0.068*

(0.038) (0.034) (0.038)

DM = 1 if import

share > 0

0.914*** 0.915*** 0.951***

(0.321) (0.308) (0.316)

Input tariff x import

share

-0.030*

(0.018)

Import share 0.899***

(0.234)

Input tariff x DM x

DX

-0.039*** -0.036***

(0.006) (0.010)


share x export share

-0.120***

(0.018)

DX = 1 if export

share > 0

0.406*** 0.419***

(0.023) (0.073)

Export share 0.123**

(0.060)

DFDI = 1 if foreign

share 0.1

0.103***

(0.035)

Foreign share 0.477***

(0.059)

Island and year effect yes yes yes yes yes yes

Firm fixed effect yes yes yes yes yes yes

Observations 253,911 253,911 253,911 253,911 253,911 253,911

F-test 89 83.0 73.7 417 384.7 88.6

R-squared 0.60 0.64 0.70 0.71 0.72 0.65

Notes: Robust standard errors in the parenthesis.

***Significant at, or below, 1 percent.

**Significant at, or below, 5 percent.

*Significant at, or below, 10 percent.

Table 3 presents the impacts of tariff reductions on product variety. Column 1

shows that output tariff reductions have insignificant impacts on product variety, even

when we include input tariffs in the estimations presented in Columns 2–6, whereas

input tariff reductions significantly increase product variety. Column 2 shows that 1

percent of input tariff reduction will increase product variety by 3.15 percent. When

16

we control for the interaction of input tariff reduction with importing and exporting

firms, it is shown that 1 percent of input tariff reduction will increase product variety

by around 2.7–2.8 percent, as presented in columns 3–5.

Column 4–5 shows 1 percent input tariff reduction will increase product variety

by 3.5 percent, which is a result of input tariff reductions and their interaction with

exporting firms that use imported inputs as their product; their interaction with

importing firms per se does not provide any significant contribution to increased

product variety. The results are consistent throughout the estimations.

Columns 4–5 also show that importing and exporting firms have a tendency to

have more product variety than the average firms by 0.18 percent and 0.05–0.06

percent, respectively, but multinational firms do not necessarily have more product

variety.

South Korea’s manufacturing firms in 1990–1998 showed a likelihood to increase

more product varieties after entering an export market which was due to the effects of

exporting activities on product development are larger than the effects of them on

cutting the number of product (Hahn, 2012). In the case of firms in Mexico, it is

claimed that a new exporting firm usually starts ‘small’ in terms of both values and

number of exported products. This could be a reason that there is a substantial degree

of product turnover at the firm product level in response to declining trade costs

(Iacovone and Javorcik, 2008). In a dynamic setting, Costantini and Melitz (2008)

predict that a new exporter is likely to increase product variety one year prior to

entering an export market and after two years in the export market, and the firm

subsequently tends to specialise in a certain number of products that give it optimal

profit.

17

Table 3: The Impacts of Tariff Reductions on Product Variety

Fixed Effect Estimations

Dependent Variable: Product Variety (ln(number of goods))

(1) (2) (3) (4) (5) (6)

Output tariff -0.133 0.051 0.057 0.063 0.059 0.0637

(0.140) (0.115) (0.120) (0.121) (0.120) (0.122)

Input tariff -

3.154***

-

2.764***

-2.711*** -2.773*** -2.816***

(0.678) (0.859) (0.822) (0.836) (0.782)

Input tariff x DM -1.050 -0.858 -0.859

(0.818) (0.854) (0.852)

DM = 1 if import

share > 0

0.182*** 0.185***

(0.062) (0.062)


share

-1.388

(1.218)

Import share

Input tariff x DM x

DX

-0.782** -0.812**

(0.396) (0.413)



-3.584***

(0.934)

DX = 1 if export

share > 0

0.051** 0.060**

(0.026) (0.029)

Export share 0.030

(0.059)

DFDI = 1 if foreign

share 0.1

-0.029

(0.020)

Foreign share -0.007

(0.015)

Island and year

effect

yes yes yes yes yes yes


Size of firm effect yes yes yes yes yes yes

Observations 253,911 253,911 253,911 253,911 253,911 253,911

F-test 89.9 43.9 49.1 81.2 77.2 85.2

R-squared 0.20 0.20 0.20 0.27 0.28 0.27





18

Table 4 presents the impacts of tariff reductions on product quality. Column 1

shows 1 percent output tariff reduction will increase product quality by 0.15 percent.

But when we include input tariffs and their interaction with firm characteristics that

determine product quality, out tariff reduction does not significantly affect product

quality. Further, comparison of columns 1 and 2–6 suggests there is an omitted

variable bias in column 1. Column 2 shows that 1 percent of input tariff reduction will

increase product quality by 1.45 percent. Columns 2–6 show that output tariff alone

does not significantly affect product quality.

Column 3 shows that 1 percent of input tariff reduction will increase product

quality by 1.5 percent which is consistent throughout estimation results presented in

columns 4 and 5.

Column 5 shows that 1 percent of tariff reduction alone will increase product

quality by 1.67 percent and the interaction of input tariff reductions and exporting

firms that use imported products as their inputs will increase product quality by 0.12

percent, whilst the interaction of input tariff reduction and importing firms will reduce

product quality by 0.29 percent. Tariff reduction and its interaction with importing and

exporting firms that use imported inputs all bring together the effect of 1 percent of

input tariff reductions will increase product quality by 1.5 percent.

It is interesting to see that the interaction of input tariff reduction and importing

firms will decrease product quality, but the interaction of input tariff reduction and

exporting firms that use imported products as their inputs will increase product quality.

One of explanations could be that importing firms tend to import goods due to

lower prices and sell their products in the domestic market. The importing firms that

use imported products as their inputs, however, tend to import products not only due

to lower prices but also taking into consideration the quality of imported products to

be able produce output products of a certain quality level, and thus the interaction of

input tariff reductions and exporting firms that use imported products as their inputs

will increase product quality.

Our findings are consistent with a study conducted by Fan et al. (2013) that look

at the case of China. They explained that reductions in import tariffs will encourage

firms to choose higher-quality imported inputs. The higher-quality inputs will induce

firms to produce higher-quality products (i.e. higher priced-products).

19

Table 4: The Impacts of Tariff Reductions on Product Quality

Fixed Effect Estimations

Dependent Variable: Product Quality (ln(unit value of goods))

(1) (2) (3) (4) (5) (6)

Output tariff -

0.153***

-0.057 -0.059 -0.056 -0.066 -0.047

(0.061) (0.046) (0.047) (0.047) (0.049) (0.044)

Input tariff -

1.450***

-

1.539***

-

1.504***

-

1.670***

-1.459

(0.193) (0.177) (0.180) (0.149) ((0.179)

Input tariff x DM 0.324*** 0.325***

0.287***

(0.120) (0.121) (0.094)

DM = 1 if import share

> 0

-

0.033***

-

0.033***

-

0.024***

(0.009) (0.009) (0.007)


share

0.468**

(0.235)

Import share -

0.060**

(0.016)

Input tariff x DM x DX -0.066** -

0.115**

(0.033) (0.058)



-0.131

(0.066)

DX = 1 if export share >

0

0.037***

0.059***

(0.021) (0.022)

Export share 0.006**

(0.003)

DFDI = 1 if foreign

share 0.1

-0.071

(0.044)

Foreign share 0.142

(0.011)

Island and year effect yes yes yes yes yes yes


Size of firm effect yes yes yes yes yes yes

Observations 253,911 253,911 253,911 253,911 253,911 253,911

F-test 49.3 84.0 105.4 110.6 136.8 110

R-squared 0.38 0.38 0.38 0.39 0.39 0.31





20

5. Conclusions

The main value added of this paper is that we provide insights on how input tariff

reductions affect value added. The rich information on firm and product-level data of

Indonesia’s manufacturing surveys allow us to test the hypotheses on how Input tariff

reductions affect value added. Input tariff reductions increase value added via product

variety and quality.

A reduction of 1 percent in input tariff will increase value added by 0.02 percent.

The impacts of input tariff reductions on product variety and quality are not only driven

by their own channels, but also magnified by their interaction with exporting firms that

use imported products as their inputs. A reduction of 1 percent in input tariff will

increase product variety by 3.5 percent and product quality by 1.5 percent.

We hypothesised that a reduction in input tariff could affect final product variety

and quality due to greater variety of inputs or better quality of inputs. Differentiating

complementarity amongst domestic and foreign inputs and quality of inputs would be

an area for future research.

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22

Appendix

A.1. Imported Inputs, Input Tariffs, Product Variety, and Quality

Correlation between imported inputs and product quality and variety

𝑁𝑗 = [1 −𝛾𝑗

(𝑝𝑞𝑗− 𝛾𝑗) (𝜂 − 1)

] 𝛼𝜂−1𝑃𝑄

1−𝜂𝜂

𝜑𝑖

𝜂−1𝜂

With as 𝑝𝑞𝑗≥ 𝛾𝑗 , 𝑝𝑞𝑗

≥𝜂

(𝜂−1)𝛾𝑗

(15)

𝜕𝑁𝑗

𝜕𝑃𝑀𝑖

=

[

−

𝛾𝑗𝑝𝑞𝑗

(𝑝𝑞𝑗

− 𝛾𝑗)

2

𝜂𝑃𝑀𝑖

𝜇(𝑚) (𝑤1−𝜇 + 𝑃𝑀𝑖

1−𝜇(𝑚))

]

𝛼𝜂−1𝑃𝑄

1−𝜂

𝜂𝜑

𝑖

𝜂−1

𝜂< 0

(15.1)

Correlation between input tariffs, imported inputs and product quality

𝑝𝑞𝑗= 𝛼𝑃𝑄

𝜂−1

𝜂 𝛾𝑗

1

𝜂 where 𝛼 ≡ [𝑅

𝑘1(𝜂−1)]

1

𝜂

(16)

𝜕𝑝𝑞𝑗

𝜕𝑃𝑀𝑖

=𝛼𝑃

𝑄

𝜂−1𝜂

𝛾𝑗

1𝜂𝑃𝑀𝑖

−𝜇

𝜂(𝑤1−𝜇+𝑃𝑀𝑖

1−𝜇)

(16.1)

𝜕𝑝𝑞𝑗

𝜕𝑃𝑄=

𝜂−1

𝜂𝛼𝑃𝑄

𝜂−2

𝜂 𝛾𝑗

1

𝜂

(16.2)

23

A.2. Profit as a Function of Product Variety and Product Quality

Note: the simulation of the profit function uses random numbers.

p

n

𝜋

p p

N

N

𝜋 𝜋

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