Imported Inputs in Indonesia's Product Development

ERIA-DP-2015-55
ERIA Discussion Paper Series
Imported Inputs in Indonesias

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 Indonesias 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 onepercent 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.
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).
Indonesias manufacturing sector was amongst seven gainers in the share of the
worlds manufactured products over the past three decades, even though relatively
small, in terms of contribution to the worlds value added in manufacturing in which
Indonesias contribution increased from 0.1 percent in 1970 to 1.8 percent in 2011.
The discussion on variety and quality of a countrys exports is in Hummels and Klenow (2005).
Figure 1: Indonesia is One of the Top7 Gainers in the Share of Manufacturing

Value Added to the World (19702012)
25%
3.5%
3.0%
20%
2.5%
15%
2.0%
1.5%
10%
1.0%
5%
0.5%
0%
0.0%
1970 1975 1980 1985 1990 1995 2000 2005 2010

Canada
France
Italy
United Kingdom
1970 1975 1980 1985 1990 1995 2000 2005 2010
China
Germany
Japan
India
Indonesia
Poland
Korea
Thailand
Turkey
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 Indonesias 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 Indonesias 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
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.
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
ASEAN5 (Malaysia, Philippines, Singapore,

Thailand, and Viet Nam)
Domestic goods
Domestic services
Domestic goods
Domestic services
Foreign goods
Foreign services
Foreign goods
Foreign services
Agriculture
Agriculture
Mining
Mining
Food and beverages
Food and beverages

Textiles, clothing and footwear
Textiles, clothing and
Wood and paper
Wood and paper

Chemicals
Chemicals
Basic metals
Basic metals
Machinery
Machinery
Electrical equipment
Electrical equipment
Transport equipment
Transport equipment
Manufacturing nec
Manufacturing nec
20
40
60
80
100
20
40
60
80
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 Indonesias
exports of manufactured products; however, if we examine their composition,
100
Indonesias 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
Indonesias 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: Indonesias Exports of Machinery
and Parts were Lower than those of its Large Emerging Peers
Exports, 2011
India
Imports, 2011
India
12%
Indonesia
Indonesia
15%
China
23%
Brazil
Machinery
10%
25%
China
20%
0%
20%
19%
Brazil
20%
30%
21%
40%
0%
Machinery parts and components
Machinery
10%
20%
30%
40%
Machinery parts and components
Source: Authors calculations based on UNCOMTRADE, using SITC Rev 35 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.
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 nonhomothetic preferences over heterogeneous goods with constant elasticity of
substitution.
= 0 + ln()
with < 1
(1)
0 stands for homogeneous goods, and is normalised to 1. denotes quantity of

heterogeneous goods, and () is the quantity consumed of variety , and > 1 is the
elasticity of substitution between heterogeneous good varieties, and the variety is
continuum [0, ]. is an index of horizontally heterogeneous goods.
= [
1
() ]
(2)
with > 1
is aggregate expenditure in this sector. The quantity of consumed goods of

variety, , could be rewritten as a function of expenditure:
() =
(3)
()
Given the quality of goods produced, each firm can choose the continuum of prices,
(). Suppose that each firm has the same marginal cost for all its varieties, =
(). The Price index can be written as:
1
1
(4)
= ( 1
)
=1
2.2. Production
Suppose there are factors of production, capital, labour, and material , , and
. Each firm j, [1, ] 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 () have the following costs and
profit functions:
= + = 0 + 0
max
( ,0 )0
(5)
= 0 ( ) 0
(6)
The optimal choice of price is = .
2.2.2. Profit function in monopolistic competition market

The heterogeneous goods are produced in a monopolistic competition ()
market.
1
= (
(7)
with > 1
is cumulative productivity of labour and input material. is the number of unit

labour. is variety of input material, and is the number of varieties of input
material used in producing product . is the number of input material varieties,
[0, ] and are the numbers of variety of input material used in producing product
. Let be quantity of input material and the quantity index of input material.
is the quantity of input material -th that is used in producing the -th product and
is the cumulative quantity index of all input material used in production of variety .
is the elasticity of substitution of factors of production (e.g. elasticity of substitution
between labour and material or amongst materials).
= (
1
1
)
(8)
stands for the price of material and stands for the price of material used
in production of variety . is an index price of material and is a cumulative
index of the price of all input materials in production of variety .
= (
1
1
1
)
(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 ISIC9 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, 0 , and marginal cost of new
varieties which is constant across varieties, 1 . is the number of varieties produced
by firm j and a firm produces at least one variety of good, > 0.
The cost function:
= + = 0 + + 0 + 1
(10)
The total production and cost functions could be written as follows.
= =
1
(
(11)
= 0 + (1 + + )
(12)
The profit function in the monopolistic competition market is as follows.

Max
( , )0
= ( ) 0 1
(13)
With as the marginal cost of labour and material and 1 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.
1
1
1
( ))
(14)
Marginal cost of new variety 1 depends on prices of materials, . The prices of input
material depend on domestic input prices, , and imported input prices which are
also affected by import tariffs,, = ( ,

(
, )). 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.
= [1
( ) ( 1)
1 1
(15)
With as , (1)
The prices of output depend on import tariffs,, = ( , ). The optimal choice of
price can obtained as follows.
1
= where
(16)
[ (1)]
1
Where is the share of expenditure to marginal cost of new varieties. The optimal
functions of profit , and are in Appendix.
10
3. Estimation Strategy and Data
3.1. Estimation Strategy

We will test estimate the impacts of output and input tariffs on output, . Output
here will be measured by real value added per worker.
ln ( ) = 0 + 1 + 2 + 3 + + +
(17)
is a fixed effect for time-invariant firm characteristics, and is year-fixed

effect. is time-variant firm characteristics. is output tariff by ISIC5 digit.
is input tariff by ISIC5 digit. As firms are price takers and do not have any power to
determine prices that could affect tariff, 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. is the number of variety of products produced by firm at time .
ln ( ) = 0 + 1 + 2 + 3 + + +
(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. is the prices of products produced by firm
at time . The price is corresponding to unit value, which represents quality of
products.
ln ( ) = 0 + 1 + 2 + 3 + + +
11
(19)
3.2.Data
The main data sources are Indonesias 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 HS9 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
= where is
the cost share of input in industry . 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 Indonesias inputoutput data for 2000, 2005, and
2009. The concordance of the HS9 digit to ISIC5 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 HS9 digit.
A firm is defined to produce a new variety if it could produce a new good with a new
product code in the HS9 digit classification. So the number of varieties of goods is
defined as the number of total varieties at HS9 digit.
12
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
Output tariff
Input tariff
Ln (real value added per worker)
Ln (number of goods)
Ln (output prices)
Import share
DM = 1 if import share > 0
Export share
DX = 1 if export share > 0
Foreign share
DFDI = 1 if foreign share 0.1
Observations
Mean
253,911
253,911
253,911
253,911
253,911
253,911
253,911
253,911
253,911
253,911
253,911
0.081
0.065
4.709
0.479
5.052
0.093
0.254
0.127
0.127
0.070
0.479
Standard
Deviation
0.046
0.017
1.264
0.650
0.325
0.235
0.435
0.295
0.295
0.181
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.
13
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.
14
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)
Output tariff
0.024***
(0.006)
Input tariff
0.017***
(0.002)
0.129***
(0.021)
Input tariff x DM
DM = 1 if import
share > 0
(5)
(6)
0.017***
(0.002)
0.108***
(0.030)
-0.065*
(0.038)
0.914***
0.016***
-0.016***
-0.017***
(0.003)
-0.105***
(0.003)
-0.098***
(0.003)
-0.116***
(0.282)
-0.058*
(0.034)
0.915***
(0.031)
-0.068*
(0.038)
0.951***
(0.025)
(0.321)
(0.308)
(0.316)
Input tariff x import

share
-0.030*
(0.018)
0.899***
(0.234)
Import share
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
Island and year effect
Firm fixed effect
Observations
F-test
R-squared
yes
yes
253,911
89
0.60
yes
yes
253,911
83.0
0.64
yes
yes
253,911
73.7
0.70
yes
yes
253,911
417
0.71
yes
yes
253,911
384.7
0.72
0.477***
(0.059)
yes
yes
253,911
88.6
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 26, 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
15
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 2.72.8 percent, as presented in columns 35.
Column 45 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 45 also show that importing and exporting firms have a tendency to
have more product variety than the average firms by 0.18 percent and 0.050.06
percent, respectively, but multinational firms do not necessarily have more product
variety.
South Koreas manufacturing firms in 19901998 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.
16
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)
Output tariff
-0.133
0.051
0.057
0.063
(0.140)
(0.115)
(0.120)
(0.121)
Input tariff
-2.711***
3.154*** 2.764***
(0.678)
(0.859)
(0.822)
Input tariff x DM
-1.050
-0.858
(0.818)
(0.854)
DM = 1 if import
0.182***
share > 0
(0.062)
share
(5)
0.059
(0.120)
-2.773***
(6)
0.0637
(0.122)
-2.816***
(0.836)
-0.859
(0.852)
0.185***
(0.782)
(0.062)
-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
Island and year

effect
Firm fixed effect
Size of firm effect
Observations
F-test
R-squared
-0.007
(0.015)
yes
yes
yes
yes
yes
yes
yes
yes
253,911
89.9
0.20
yes
yes
253,911
43.9
0.20
yes
yes
253,911
49.1
0.20
yes
yes
253,911
81.2
0.27
yes
yes
253,911
77.2
0.28
yes
yes
253,911
85.2
0.27

17
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 26 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 26 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).
18
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)
Output tariff
-0.057
-0.059
-0.056
0.153***
(0.061)
(0.046)
(0.047)
(0.047)
Input tariff
1.450*** 1.539*** 1.504***
(0.193)
(0.177)
(0.180)
Input tariff x DM
0.324*** 0.325***
(0.120)
0.033***
(0.009)
DM = 1 if import share
>0
(0.121)
0.033***
(0.009)
(5)
-0.066
(6)
-0.047
(0.049)
1.670***
(0.149)
(0.044)
-1.459
((0.179)
0.287***
(0.094)
0.024***
(0.007)

share
0.468**
(0.235)
0.060**
(0.016)
Import share
Input tariff x DM x DX
-0.066**
(0.033)
0.115**
(0.058)

-0.131
(0.066)
DX = 1 if export share >

0
0.037***
(0.021)
0.059***
(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
Firm fixed effect
yes
yes
Size of firm effect
yes
yes
Observations
253,911
253,911
F-test
49.3
84.0
R-squared
0.38
0.38
19
yes
yes
yes
253,911
105.4
0.38
yes
yes
yes
253,911
110.6
0.39
yes
yes
yes
253,911
136.8
0.39
yes
yes
yes
253,911
110
0.31
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
Indonesias 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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21
Appendix
A.1. Imported Inputs, Input Tariffs, Product Variety, and Quality
Correlation between imported inputs and product quality and variety
= [1
] 1
( ) ( 1)
(15)
With as , (1)
1 1

1
=
< 0
2
1
( ) ( ) ( 1 + ( ))
[
]
(15.1)
Correlation between input tariffs, imported inputs and product quality

1
= where [
1 1
1
( 1 + )
(16)
]
(1)
(16.1)
(16.2)
22
A.2. Profit as a Function of Product Variety and Product Quality
p
n
Note: the simulation of the profit function uses random numbers.
23
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