Trade Adjustment Costs in Developing Countries: - World Bank ...

The Duration of Trade Relationships 273Details of the model can be found in Besedeš (2008) and Besedeš and Prusa(2006b); we briefly sketch the idea here. The model begins with the realistic assumptionthat trade between parties does not just happen by chance but ratherbegins with a search—a domestic buyer searches for a foreign supplier. After payinga search cost and being matched with a foreign supplier the buyer immediatelyobserves the supplier’s efficiency. The buyer cannot immediately ascertain,however, whether the foreign supplier will be successful in fulfilling a large order.If the supplier turns out to be unreliable, relationship-specific fixed cost investmentsare lost and the buyer must search again. Because of the risk of losing thelump-sum investment, the buyer might forestall making the investment and insteadjust make several small-volume purchases in order to learn about the supplier’sreliability. If the supplier proves to be reliable, the buyer makes theinvestment necessary for a large order.The model implies there are three possible actions for the buyer who has justbeen matched with a foreign supplier: start big (which means the relationshipspecificinvestment was made), start small (which means sampling in order todetermine the quality of the match), or reject the supplier. Besedeš (2008) identifiesfive implications of the Rauch and Watson (date) model as applied to formationand duration of US import trade: (1) some relationships will start withsmall initial order while others will start with larger ones, with larger ones enjoyingan advantage in the form of a longer duration; (2) higher supplier reliabilitywill result in a larger initial order and longer lasting relationships; (3) lowersearch costs increase initial order and duration; (4) a relationship is most likelyto fail in its early stage; and (5) a small fraction of relationships will end with abuyer switching to a new supplier. Besedeš (2008) studies these implications usingdata on US imports from developing as well as developed countries. Rauch andWatson (2003) developed their model with developed country buyers searchingfor developing country suppliers. Besedeš (2008) shows that many features ofthose relationships hold for those between developing countries as well.Since the model is silent on what constitutes a small initial order, Besedeš(2008) divides relationships into five groups based on initial order: (1) under$10,000; (2) between $10,000 and $50,000; (3) between $50,000 and $100,000;(4) between $100,000 and $1,000,000; and (5) those above $1,000,000. More thana half of all US import relationships start under $10,000, while only four per centcommence with more than $1,000,000 indicating that many import relationshipscommence in a ‘testing the water’ phase. Estimated Kaplan–Meier survival functionsand corresponding hazard functions support the model’s implications asseen in Figure 17.2. Relationships starting with larger initial orders exhibit consistentlyhigher survival probabilities. Regardless of initial size, hazard rates forall relationships are the highest in early years and continuously decline. However,while they approach zero as relationships mature they never fully decline to zeroindicating that some mature and successful relationships end when buyers switchto new suppliers.