Trade policy uncertainty, organization of firms, and the form of international trade

Abstract This paper investigates the hypothesis that lower trade policy uncertainty (TPU) reduces the share of intrafirm trade in total trade. A significant change in US‐China TPU occurred in 2001 when China joined the WTO, providing a natural experiment to test this hypothesis. Using a difference‐in‐differences approach with industry‐level US data, I examine the trade effects of this change. The results indicate that the reduction in TPU between the US and China led to a significant increase in both US arm's‐length and intrafirm imports from China compared to pre‐WTO levels. Notably, the effect of TPU on arm's‐length trade is approximately twice that on intrafirm trade, with the disparity largely attributed to sunk costs. A simple model of production location and ownership choice under policy uncertainty provides a conceptual framework for understanding these findings.