Foreign competition and the durability of US firm investments
| DOI | http://doi.org/10.1111/1756-2171.12286 |
| Author | Philippe Fromenteau,Jan Tscheke,Jan Schymik |
| Date | 01 September 2019 |
| Published date | 01 September 2019 |
RAND Journal of Economics
Vol.50, No. 3, Fall 2019
pp. 532–567
Foreign competition and the durability of US
firm investments
Philippe Fromenteau∗
Jan Schymik∗∗
and
Jan Tscheke∗∗∗
How does the exposure to product market competition affect the investment horizon of firms? We
study if firms have an incentive to shift investments towardmore short-term assets when exposed to
tougher competition. Based on a stylized firm investment model, we derive a within-firm estimator
using variation across investmentswith different durabilities. Exploiting the Chinese World Trade
Organization (WTO) accession, we estimate the effects of product market competition on the
composition of US firm investments. Firms that experienced tougher competition shifted their
expenditures toward investments with a shorter durability. This effect is larger for firms with
lower total factor productivity.
1. Introduction
Firms invest in expectation of some future benefits. A vigorous policy debate is in progress
over the origins and consequences of short-term corporate behavior: when firms in the economy
face short-term incentives and do not invest sufficiently long term into assets that pay off in
the distant future, this can be impedimental for economic growth. As short-term investments
depreciate earlier, net investments tend to fall, and firms need to refinance more frequently.1
The literature has identified that credit crunches, uncertainty, investor pressures, or agencyprob-
lems can be causal for short-term investment behavior (see Aghion et al., 2010; Garicano and
Steinwender, 2016; Terry, 2015; Garicano and Rayo, 2016; B´
enabou and Tirole, 2016). In this
∗Ludwig Maximilian University of Munich; philippe.fromenteau@econ.lmu.de.
∗∗University of Mannheim; jschymik@mail.uni-mannheim.de.
∗∗∗OECD; jan.tscheke@oecd.org.
We wouldlike to thank Andrew Bernard, Harald Fadinger, Gabriel Felbermayr,Dalia Marin, Udo Kreickemeier, Georg
Schaur, Uwe Sunde, Chad Syverson, Alexander Tarasov,Michael Weber, Joachim Winter, two anonymous referees, and
various seminar participants at LMU Munich, Mannheim, the Midwest Trade Meetings (Purdue), and the International
Economics WorkshopG ¨
ottingen for helpful comments and suggestions. Weare indebted to Elizaveta Filatova for superb
research assistance. Financial support from the DFG - CRC TR224 (Schymik) is gratefully acknowledged.
1According to Bureau of Economic Analysis data, there has been a fall in the fraction of net investments in gross
investments of US private businesses during the period between 1995 and 2009, suggesting that a largerpropor tion of
gross investments was conducted to replace old capital stock.
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FROMENTEAU, SCHYMIK AND TSCHEKE / 533
article, we put forward another reason for corporate short-termism: we argue that foreign com-
petition can induce firms to distort investments awayfrom assets that pay off in the distant future
toward short-term assets.
Falling trade barriers leading to a rise in international trade flows are a defining feature of the
past century. The associated increase in competitive pressure from abroad can threaten domestic
firms and affect their investment behavior. When tougher competition reduces the expectations
of future profitability, firms havean incentive to shift investments toward more short-term assets.
To guide our empirical analysis, we provide a simple model. We consider a firm in a two-
period economy which engages in twotypes of investment: a short-term one and a long-term one.
Whereas short-term investments reduce production costs today and yield an immediate payoff,
investments into more durableassets reduce future production costs and therefore pay off at a later
point in time.2When tougher competition from abroad reduces the rents on long-term investments,
firms are incentivized to shift their investment expenditures toward nondurable investments. To
estimate the effect of foreign competition on the investment composition inside firms, weuse our
model to derive a within-firm difference-in-differences estimator.Our model predicts that within
a firm in a given year, tougher foreign competition should lead to a relatively larger reduction
in long-term investments vis-`
a-vis short-term investments. Consider, for example, a firm that
chooses between investing into computer equipment or some new machinery where computers
depreciate faster than machinery. In the optimum, the firm invests such that the return on the
marginal investment are equal for both categories. If competition now reduces profits in the long
run, this diminishes returns on machinery and the firm tilts its investments toward computers.
We use data for the population of stock-listed manufacturing firms in the United States
between 1995 and 2009, and exploit the Chinese WTO accession in 2001 as a natural experiment
to study how a change in competition prospects shapes the investment composition inside firms.
After China was granted WTO membership in 2001, the US Congress was not anymore in the
position to annually ratify tariff rates on Chinese imports. We argue that this abolition of the
opportunity to protect US industries led to an increase in the exposure to competition from
China, particularly for firms in industries that historically have been protected by high tariffs.
Furthermore, firms in US industries that are more low-skill-intensive in their production might
also be affected more severely, because these industries face comparative disadvantages vis-
`
a-vis Chinese producers. As listed firms disclose investment expenditures across different asset
categories which differin their durability, we can exploit variation in durability across asset groups
to distinguish between short- and long-term investments, similar to Garicano and Steinwender
(2016).3With the data at hand, we estimate how changes in the sectoral degree of competition
lead to a shift of investments within firms. Based on our sample of listed manufacturing firms, we
find that increasing Chinese import competition reduced the most durable investments more than
the least durable investments. The estimated economic significance of our estimates compares to
the effect that Garicano and Steinwender (2016) estimate for the financial crisis on investment of
Spanish firms.4
We find this result to be robust to controlling for several alternative channels that could
counteract our results. First, the level of import competition could,for instance, be cor related with
developments in the domestic industry. For example, if US industries become more productive
over time, this might lead to relatively more long-term investments and a lower level of import
competition. Therefore, we control for changes in total factor productivity, capital- and low-
skill-intensity of the US manufacturing industries. Second, we find our results to be robust to
2The same argument holds when investments increase the perceived-qualityof goods instead of reducing produc-
tion costs.
3Specifically,we consider seven investmentcategories, which we group according to their durability by means of de-
preciation rates derived from accounting rules: Advertising expenditures, Computer expenditures, expenditures on R&D,
expenditures on Transportation Equipment, expenditures on Machinery, expenditures on Buildings, and expenditures
on Land.
4See Section 4 for a deeper discussion of the economic magnitudes.
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534 / THE RAND JOURNAL OF ECONOMICS
controlling for foreign inputs, export opportunities, or financial frictions, and alternative measures
of investment life spans. Last, as our estimation is based on the within-firm responses across
investment categories, we are able to account for potential alternative firm-specific demand or
technology shocks.
As the residual demand is relatively more elastic for less profitable firms, we expect that we
observe stronger adjustments of the investment composition to an increase in foreign competition
within the less productive firms of each industry. Thus, weexpect that firm heterogeneity matters
for the relative size of this effect. Consider, for example, two different firms that choose to
invest into computers or machinery, one firm with higher unit costs than the other. Whereas
tougher competition shifts up the residual demand price elasticities for both firms at any given
demand level, the long-term profits for the firm with higher costs fall more compared to the
profits of the firm with lower costs, because the high-cost firm charges higher prices and a
lower markup. Therefore, weexpect a stronger shift away from long-term machinery investments
inside firms with lower productivity. We investigate this role of firm heterogeneity on investment
responses empirically and find support for that prediction. When comparing investment responses
across the within-industry total factor productivity (TFP) distribution, we find that shifts in
investments toward less durable assets as a response to foreign competition are more vigorous
among low productivity firms.
Generally,this article relates to the literature that analyzes within-firm adjustments to interna-
tional competition. Bloom, Draca, and Van Reenen (2016), Hashmi (2013), and Gorodnichenko,
Svejnar, and Terrell (2010) examine the impact of foreign competition on innovation activities
inside firms. Bustos (2011) and Lileeva and Trefler (2010) study how access to foreign markets
can induce investments in technology upgrading. Whereas these studies analyze the absolute
level of firm investments and innovation activities in response to trade liberalization, our focus is
on changes in the composition of investments within firms with respect to more or less durable
assets. Furthermore, the literature on multiproduct firms suggests that the exposure to tougher
foreign competition incentivizes firms to shift their product portfolio toward their core products
(see, e.g., Eckel and Neary, 2010; Bernard, Redding, and Schott, 2010; Nockeand Yeaple, 2014;
or Mayer, Melitz, and Ottaviano, 2014). Whereas these studies analyze within-firm adjustments
to competition with respect to the production side of firms, our study considers a within-firm
adjustment with respect to the capital side of firms.
Furthermore, as investments are inherently a forward-looking factor choice, we also con-
tribute to a growing literature that analyzes how economic conditions affect the beliefs of eco-
nomic agents and determine firm decisions (see Bachmann, Elstner, and Hristov, 2017; Buchheim
and Link, 2018; Coibion, Gorodnichenko, and Kumar, 2018; Chen et al., 2017; Gennaioli, Ma,
and Shleifer, 2016). We think that there are at least two channels how the increase in Chinese
import competition can affect the durability of investments. First, whenthe realization of tougher
competition lowers profits, firms could expect to become insolvent with a higher probability, as
suggested by the selection mechanism in models of firm heterogeneity `
a la Melitz (2003).5Second,
the expectation of tougher competition in the future might let firms expect lower future price-cost
margins, and thus a lowerreturn on long-ter m investments.As both economic mechanisms reduce
the expected quasi-rents from durable investmentssuch that competition discourages investments
into durable assets, we do not aim to distinguish between them, and rather aim to estimate the
joint effect of competition.
This article is also related to a nascent literature that studies the impact of international trade
on corporate finance. Fresard (2010) finds that large corporate cash holdings lead to systematic
future market share gains at the expense of industry rivals when an industry is hit by an import
competition shock. Valta(2012) studies how the costs of bank credit respond to foreign competi-
tion, and finds that firms face higher loan spreads when import competition toughens. Xu (2012)
studies the financing response during periods of higher competition, and finds that firms reduce
5Garicano and Steinwender (2016) study this channel empirically in light of a credit crunch.
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