An experimental test of trade hysteresis: market exit and entry decisions in the presence of sunk costs and exchange rate uncertainty

Abstract

In the 1980s, the unresponsiveness of trade flows to exchange rate swings inspired models in which sunk costs in combination with exchange rate instability generate trade hysteresis, meaning that temporary exchange rate misalignments have a persistent effect on trade. This paper furnishes an empirical complement to the theoretical literature. First, it describes a computerized experiment in which 100 subjects generated over 1000 decisions on market entry and exit under conditions congruent with a model of trade hysteresis developed by Paul Krugman. Secondly, these data are used to test the main predictions arising from the model. Our experiment bears out the main qualitative predictions of Krugman's model; in particular, that firms' trading policy is unresponsive to exchange rate movements over a wide range of values. Moreover, in the repeated-decision setting of the experiment, we find evidence that the stochastic behaviour of subjects' entry- and exit-price decisions tend towards consensus as they gain experience, even though they do not interact with one another during the experiment. This effect, which is not predicted in Krugman's model, supports the supposition that behaviour at the firm level in the presence of sunk costs and exchange rate uncertainty is a plausible microeconomic foundation for otherwise puzzling macroeconomic phenomena.

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