Product Differentiation, and the Composition of Trade Across Dissimilar Nations Ahmad Lashkaripour∗ May 2015 First draft: November 2013 Abstract Standard gravity models describe the volume of trade in a multilateral world, but overlook the commodity composition of trade. I develop a novel view of comparative advantage that reconciles the gravity equation with three basic facts about the composition of trade: (i) the effect of geography on the price composition of exports, (ii) the effect of GDP per capita on the price composition of exports, and (iii) the systematically higher trade-to-GDP ratio of rich countries. My approach delivers a unified model, which fully describes both the volume and the composition of trade among nations that are dissimilar in terms of geography and income. A remarkable feature of the unified model is that, despite homothetic preferences, rich and poor countries have systematically different consumption structures. I estimate the unified model using bilateral trade data on 100 countries and compare it to a special case, which delivers the pure gravity equation. The unified model fits the data significantly better with an R2 that is 43 percent higher than the pure gravity model. The estimated gains from trade are substantially larger than the pure gravity model, and more unequally distributed across nations. Importantly, when accounting for the role of composition, further liberalization of trade systematically favors poor and remote nations. 1 Introduction The contemporary theories of international trade deliver the gravity equation, by linking the characteristics of a country to the volume of its trade. However, they do not deliver systematic predictions about how country-specific characteristics determine the commodity composition of trade. With the dramatic growth of trade between dissimilar nations, and the availability of microlevel data, it has become more evident that dissimilar countries trade dissimilar goods. Evidence indicate that: ∗ I am grateful to my advisors Jonathan Eaton and Stephen Yeaple for their guidance, encouragement, and support. I am also grateful to James Tybout for encouragement and various discussions on the topic. I wish to thank Bernardo Díaz de Asterloa, Alexandros Fakos, Farid Farrokhi, Cecilia Fieler, Paul Grieco, Kala Krishna, Konstantin Kucheryavyy, Felix Tintelnot and seminar participants at the University of British Columbia, Indiana University, Pennsylvania State University, University of California Santa Cruz, Drexel University, and the New Faces in International Economics conference for helpful comments and suggestions. All errors are my own. Correspondence: [email protected], http://pages.iu.edu/~alashkar/. 1 i. High-income countries import/export a higher share of their GDP. ii. High-income countries have higher aggregate (and within category) export prices. iii. Geographically distant nations trade higher-price goods (THE WASHINGTON A PPLES EFFECT ).1 The first two facts point to a systematic relationship between income per capita and the composition of a nation’s trade. The third fact points to a systematic relationship between geography and the composition of trade. All three facts are beyond the scope of standard gravity models. Three independent bodies of literature have emerged, addressing each fact individually. However, there is no unified framework that could reproduce all three facts. This paper develops an novel view of comparative advantage that collectively reproduces all three facts highlighted above. I combine this alternative view of comparative advantage with National Product Differentiation to construct a unified model of foreign trade. The unified model extends beyond standard gravity models as it systematically pins down both the volume and the composition of trade. I estimate the unified model and compare it to a special case, which delivers the pure gravity equation. I show that embedding systematic production specialization into a pure gravity model (i.e. accounting for the role of composition) tremendously magnifies the gains from trade. Moreover, when accounting for the role of composition, the gains from trade depend crucially on two national characteristics: income per capita and remoteness. To explain the commodity composition of trade across dissimilar nations, I take an alternative view from the existing literature. Existing theories (usually) require non-homothetic demand to explain the effect of per capita income and rely on additive (specific) trade costs to account for the effect of geography on the composition of trade. The remaining void, however, is a general theory that reconciles the effect of per capita income with that of geography. The unified model fills this void with a simple solution that requires neither non-homotheticity nor additive trade costs. Indeed, I only relax one common assumption (of the gravity models) that is inconsistent with micro level evidence. Standard gravity models assume that the scope for product differentiation is the same across all goods.2 I relax this assumption, and allow for two types of goods, which offer different scopes for product differentiation (a highly-differentiated, low-σ, type and a less-differentiated, high-σ, type).3 In equilibrium, patterns of trade are determined by how countries concentrate their production and consumption across the two types of goods. Countries are characterized by their National Product Quality and Labor endowment. Advanced countries (by definition) are endowed with higher National Product Qualities, and produce more appealing varieties of both types. This entails more global demand, which drags up their equilibrium wage. The higher wage paid by advanced countries makes them comparatively disadvantaged in the less-differentiated type, which is highly price-sensitive. Consequently, high-wage countries have endogenously determined comparative advantage in the highly-differentiated (low-σ) type — i.e. the autarky 1 The first fact is documented by Limao and Venables (2001), Waugh (2010), and Fieler (2011). The second fact is documented at various levels of aggregation: Schott (2004) shows that rich countries have higher within-category export prices; Hummels and Klenow (2005) show that rich countries have higher aggregate export prices. The third fact is documented by Hummels and Skiba (2004) and Baldwin and Harrigan (2011), among others. 2 Broda and Weinstein (2006) estimate that different HS10 product categories exhibit substantially different degrees of product differentiation. At an even more desegregated level, Berry, Levinsohn, and Pakes (1995) estimate that luxury cars have systematically lower price elasticities of demand than economy cars. That is to say that luxury cars are more horizontally differentiated than economy cars. 3 Hanson and Xiang (2004) also exploit across-sector differences in the degree of product differentiation to identify the home market effect. 2 relative price index of the highly-differentiated type is lower in high-wage countries.4 Low-wage countries, meanwhile, have comparative advantage in the less-differentiated (low-σ) type. That being the case, in equilibrium, high-wage countries concentrate their production on the highly-differentiated type, whereas low-wage countries concentrate their production on the less-differentiated type. Consumption patterns are determined by what I refer to as the Home Production Effect on local consumption. In the presence of trade costs, consumers spend relatively more on the locally competitive type as it is relatively cheaper. Specifically, due to costly trade, The relative price index of the highly-differentiated (low-σ) type is lower in rich countries versus poor countries. This induces households in rich countries to consume relatively more of the low-σ type.5 So, remarkably, countries with identical (homothetic) preferences concentrate their consumption on different types of goods. This effect is the opposite of the Home Market Effect formalized by Krugman (1980). The Home Market Effect states that local demand dictates patterns of local production. The present model states that, when trade is costly, local production determines local consumption.6 In equilibrium, rich countries are both net exporters and the main consumers of the highly-differentiated (low-σ) type. The low-σ type is subject to a low demand elasticity and exhibits two key properties: (i) it comes with a higher markup, and (ii) it has a lower trade elasticity and is traded more heavily. Rich countries have higher trade-to-GDP ratios because they produce and consume relatively more of the low-σ type, which is traded more intensively. Rich countries have higher aggregate export prices dues to two reasons. First, rich countries sell both types of goods at a higher price due to their higher National Product Quality. Second, rich countries export relatively more of the highly-differentiated, high-markup type. The second channel is novel and points to a purely compositional effect. Similarly, distant countries trade relatively more of the highly differentiated, high-markup type. This follows from the fact that remote exporters face higher trade costs and are price-disadvantaged. That being the case, they sell relatively more of the highlydifferentiated, high-markup type, which is price-insensitive. This gives rise to THE WASHINGTON A PPLES EFFECT . In the unified model, National Product Differentiation governs the trade of similar goods between similar countries. I accommodate National Product Differentiation by letting firm-specific varieties from the same country to be closer substitutes. The unified model, therefore, nests the Armington gravity model.7 Altogether, the unified model combines the neoclassical-type trade, between dissimilar nations, with the gravity-type trade, between similar nations. This gives rise to two independent welfare-improving effects of foreign trade. First, like gravity models, trade increases the number of differentiated varieties. Second, like neoclassical models, trade induces production reallocation, which lowers the relative price index of the comparatively disadvantaged type in each country. More specifically, quality-abundant countries reallocate production towards the highly differentiated type, whereas labor-abundant countries reallocate 4 Comparative advantage in the unified model is similar to the Heckscher-Ohlin model in that it is endogenously determined. It is different from the Heckscher-Ohlin model in that it is regulated by demand. In the Heckscher-Ohlin model there are two goods, one with a production that is labor-intensive and other has a production that is capital-intensive. In the present model there are two goods, one (the low-σ type) has quality-intensive demand and the other (the high-σ type) has a quantity-intensive demand. 5 Preferences are nested CES, and consumers allocate expenditure across different types of goods based on their relative price. 6 The Home Market Effect relies on increasing returns to scale, the effect presented in this paper requires some degree of substitutability between different types of goods. 7 The Armington model implicitly assumes that varieties from the same country are perfect substitutes (which entails perfect competition). I relax this restriction, and develop a method that tractably combines National Product Differentiation with monopolistic competition. 3 production towards the less-differentiated type. Welfare improves because the relative price index of the highly-differentiated type falls in poor (labor-abundant) countries, and the relative price index of the lessdifferentiated type falls in rich (quality-abundant) nations. I estimate the unified model using bilateral trade data for 100 countries. The sample represents more than 95% of the world trade. More importantly, the sample represents countries that are vastly dissimilar in GDP per capita and geographical location. To demonstrate the merits of the unified model, I compare it to a special case that delivers the pure gravity equation. The unified model fits the data better, with an R2 that is 43 percent higher than the pure gravity model. The superior fit of the unified model stems from its ability to explain trade between both similar and dissimilar nations. Specifically, the unified model matches two margins of the data that are beyond the scope of the pure gravity model. The first margin corresponds to the sizable disparity in trade-to-GDP ratios across rich and poor countries. The unified model correctly predicts that rich countries have higher trade-to-GDP ratios, whereas the gravity model predicts the opposite. Second, the unified model allows for endogenously determined, country-specific trade elasticities. That being the case, the unified model correctly predicts the smaller distance elasticity of export flows from rich and remote countries. Moreover, in addition to better-explaining trade volumes, the unified model also performs remarkably better than the gravity model in matching (out-of-sample) facts about the price composition of exports. The commodity composition of trade plays a central role in determining welfare. Arkolakis, Costinot, and Rodriguez (2012) demonstrate that in gravity models the trade-to-GDP ratio and trade elasticity are sufficient statistics for evaluating the gains from trade relative to autarky. Gravity models mismatch tradeto-GDP ratios across rich and poor nations and counter-factually assume a common trade elasticity for all countries. By characterizing the composition of trade, the unified model matches observed trade-to-GDP ratios and delivers country-specific trade elasticities that are endogenously determined. As a result, the gains from trade (relative to autarky) are systematically larger in the unified model relative to the pure gravity model. The gains are systematically larger for rich countries, because the unified model correctly predicts that rich countries have higher trade-to-GDP ratios. The gains are systematically larger for poor countries because they import relatively more of the highly-differentiated type and have systematically lower trade elasticities.8 To quantitatively demonstrate this result, I estimate the gains from trade (relative to autarky) in both models. In the unified model the estimated gains from trade are close to 200% larger than the pure gravity model. The composition of trade not only influences the overall size of the gains from trade, but also their distribution across countries. At the current levels of globalization, different countries are importing systematically different goods. So the prospective gains from further trade liberalization depend crucially on the inherent characteristics of each country. To quantify this dependence, I estimate the prospective gains from lowering the existing trade costs by 10 per-cent. Two remarkable patterns emerge: (i) the prospective gains are systematically larger for poor countries, and (ii) compared to the pure gravity model, the prospective gains (in the unified model) are distributed in favor of remote nations. Both patterns are due to the highly-differentiated imports of poor and remote countries given the existing impediments to trade. Partially removing these impediments allows poor and remote countries to import more of the highly-differentiated type. Highly8 Imported varieties increase welfare to a larger degree if they are highly-differentiated and less substitutable with domestic counterparts. 4 differentiated varieties are not easily substitutable with domestic counter-parts, so they bring along sizable welfare gains. This paper is closely related to a contemporary literature that describes the composition of trade. Hummels and Skiba (2004), and Baldwin and Harrigan (2011) propose models that account for the effect of geography on the price composition of trade. Flam and Helpman (1987), Matsuyama (2000), and Fajgelbaum, Grossman, and Helpman (2011) explain (based on non-homtheticity) the effect of GDP per capita on price composition of exports. Fieler (2011), and Caron, Fally, and Markusen (2014) develop models (based on non-homtheticity) that reproduce the higher trade-to-GDP ratios of rich countries. This paper contribute to this literature along several key dimensions. First, it accounts for both the effect of geography and per capita income on the composition of trade. Existing theories generally confront one aspect of the data in isolation, and overlook the others. Second, the unified model preserves the standard assumptions that make gravity models tractable (e.g. homthetic CES preferences and iceberg trade costs).9 The unified model, therefore, retains the parsimony of standard gravity models and is straightforward to estimated with multilateral trade data. The main contribution of the paper, however, concerns the welfare gains from trade. I explicitly argue that the composition margin has profound effects on the gains from trade. To my knowledge, this paper is the first to show that embedding systematic specialization into a gravity model (to account for composition) tremendously magnifies the gains from trade.10 Finally, this paper contributes to a literature that combines within-product trade with across-product trade (Helpman and Krugman (1985); Markusen (1986); Davis (1995); Bernard, Redding, and Schott (2007)). The contribution is along three directions: First, the driving force behind across-product specialization in the present model is novel and consistent with micro-level evidence. Second, in the present model, acrossproduct trade delivers three principal facts regarding the composition of foreign trade—previous studies of within- and across-product trade are mute about these principal facts.11 Third, existing theories are generally confined to basic settings with two countries. This paper, however, develops and estimates a multi-country, general equilibrium model that tractably combines within-product trade with across-product trade across many dissimilar countries. The paper is structured as follows. I present the model in Section 2 and the empirical analysis in Section 3. Section 4 performs counterfactuals and quantifies the gains from trade. Section 5 concludes. 9 Competing theories usually deviate from these simple assumptions and, therefore, depend on a broader set of conditions to hold. For example, the standard explanation for the effect of geography on the export price-mix (Hummels and Skiba (2004)) imposes two conditions: (i) firms produce substitutable goods that exhibit different qualities, and (ii) trade costs are additive. The explanation for higher trade-to-GDP in rich countries (Fieler (2011), and Caron et al. (2014)) relies on two assumptions: (i) preferences are nonhomothetic, and (ii) income elastic goods are subject to lower trade elasticities. Fajgelbaum et al. (2011) requires two conditions to deliver the higher price of exports from rich countries: (i) preferences are non-homothetic, and (ii) high-quality goods are more differentiated. T HE UNIFIED MODEL, developed here, only requires one non-standard assumption: different types of goods offer different scopes for product differentiation. Yet, it collectively reproduces all three facts corresponding to composition. In THE UNIFIED MODEL, the systematic difference in consumption structure across rich and poor countries is an endogenous outcome rather than an assumption (of non-homotheticity). 10 Costinot, Donaldson, and Komunjer (2012) argue that accounting for sectoral specialization increases the gains from trade marginally. They impose, however, that sectoral specialization is regulated by sector-specific technologies. That being the case, their model does not deliver the three basic facts linking specialization to geography and income. Costinot and Rodríguez-Clare (2013) and Ossa (2012) argue that embedding multiple sectors into a gravity model magnifies the gains from trade. In both studies, however, a fixed share of income is spent on a particular sector, and intra-sector trade is governed by standard gravity forces. Therefore, while both studies account for the composition margin, they overlook systematic specialization across sectors. 11 Markusen (1986) predicts that the volume North-North trade is larger than North-South trade. This result, however, does not imply higher trade-to-GDP ratios in rich countries. As pointed out in Caron et al. (2014), one needs to further assume that income-elastic, capital-intensive goods are subject to lower trade costs to achieve results corresponding to trade-to-GDP ratios. 5 2 Theory The UNIFIED THEORY combines Monopolistic competition and National Product Differentiation in a multicountry general equilibrium framework with two types of goods. There are two driving forces behind trade: international specialization and National Product Differentiation. International specialization is motivated by comparative advantage across types, and governs across-product trade. National Product Differentiation governs within-product trade. The two forces, combined, determine the volume and the composition of foreign trade. 2.1 The Environment There are N countries; C = {1, ..., N } denotes the set of countries. Population Li , and National Product Quality αi characterize country i ∈ C. There are two types of goods: H and L. Each type comes in a continuum of firm-specific varieties. Firm-specific varieties are (horizontally) differentiated both at the firm level and at the national level. Demand. Preferences are homothetic and described by a nested-CES utility. Consumers in country i max- imize the following utility function Ui = (Uiz ) ∑ −1 −1 z∈{ H,L} where Uiz is the sub-utility corresponding to type z ∈ { H, L}. Uiz is a CES aggregator across all national varieties of type z " #1 ρz ρz N 1−ρ z z z Q ji Ui = ∑ α j j=1 The utility attained from varieties of type z produced in country j, is a Cobb-Douglas combination of the aggregate quantity, Q zji , and the quality, α j , of the imported varieties. Henceforth, I will refer to α j as the National Product Quality of country j—countries endowed with a higher α j , produce more appealing varieties of both types (H and L).12 Q zji is a CES aggregator across all the firms exporting type z from country j to i "ˆ Q zji = ω∈Ω ji q zji ρez # dω 1 ρez 1 = M jiρez q zji 12 The country-specific demand shifter, α , is not Hicks-neutral. This is essential for the results of the paper, and states that demand j for the highly-differentiated (low-σ) types is quality-intensive, whereas demand for the less-differentiated (high-σ) types is quantityintensive. Typically, to characterize trade across dissimilar countries one has to avoid Hicks-neutrality. In Fieler (2011), for example, the country-specific technology parameters are not Hicks-neutral (i.e. better overall technology makes a country relatively better in goods that have highly differentiated technologies). In the generalized framework developed by Costinot (2009), log-supermodularity implies non-neutrality of technology. The fact that country-specific demand shifters are not Hick-neutral has theoretical roots. For example, if consumers have heterogeneous tastes across varieties, and taste is Freshet-distributed, a CES-like demand will emerge (Anderson, De Palma, and Thisse (1992)). Suppose ideas are used to develop varieties that match the taste of individual consumers. If ideas arrive at constant rate and according to a Poisson distribution, then taste is Freshet-distributed. The non-neutral country-specific demand shifter, α j , would then represent the stock of ideas in country j. This result is due to Kortum (1997). 6 where q zji is the quantity purchased from a typical firm ω from country j (note that firms are homogeneous). M ji (Ω ji ) denotes the mass of firms (the set of firms) that sell from country j to i. In the above threetier nested-CES utility, is the elasticity of substitution between types H and L; σ z = 1/ (1 − ρ z ) is the ez = 1/ (1 − ρez ) is the intraelasticity of substitution between (aggregated) national varieties of type z; σ national elasticity of substitution between firm-specific varieties of type z. ez = σ z there is no The above demand structure nests both the Krugman and Armington models. When σ scope for National Product Differentiation, and the demand structure (for each type) reduces to that of Krugez → ∞, the scope for National Product Differentiation is complete, similar to the Armington man (1980). If σ model. In this paper I adopt a middle ground. Specifically, I allow for some degree of National Product Differentiation, which is the same for both types: eH − 1 e −1 σ σ = L ≡η>1 σH − 1 σL − 1 The above specification indicates that firm-specific varieties produced in the same country are closer substitutes— η → ∞ entails that varieties from the same country are perfect substitutes, like the Armington model. Importantly, type H and type L goods are systematically different. Type H offers a greater scope for product differentiation than type L: σ H < σ L ⇐⇒ ρ H < ρ L Hence, by definition, preferences for type L are quantity-intensive, whereas preference for type H are quality-intensive, i.e. ρ H < ρ L . Henceforth, I will refer to to type H as the highly differentiated (low-σ) type, and to type L as the less-differentiated (high-σ) type. To summarize the demand-side, σ z regulates the scope for product differentiation in sector (or type) z, while η regulates the degree of National Product Differentiation in the economy. In section 3, I estimate η without imposing any restrictions, which delivers an η > 1. Supply. As in Krugman (1980), firms are monopolistically competitive and homogeneous. Unlike the Krugman model, entry cost is paid locally (and separately) for each market, so there are no economies of scale. Labor is the only factor of production. One unit of labor is required to produce one unit of each type z ∈ { H, L} . The unit labor cost is the same for both types and for all countries. Exports from country j to i are subject to an additional iceberg cost, τ ji . Altogether, the marginal cost of producing type z in country j, and selling in to country i is mczji = τ ji w j where w j denotes wage in country j. Let p zji denote the price of type z, produced in country j, and sold in country i. A typical firm exporting q zji units of type z from country j to i collects a variable profit equal to π jiz = p zji − τ ji w j q zji 7 The firms use the combined variable profits from selling both types to subsidize the local entry cost, which is f e units of home labor. The free entry condition (for market i) is, therefore, given by π jiz = w j f e ∑ z∈{ H,L} The free entry condition determines M ji : the mass of firms that export from country j to i. Equilibrium. Let X zji ≡ M ji p zji q zji denote the amount spent by country i on type z = { H, L} goods produced in country j. Utility maximization implies: X zji Pjiz = αj !1−σz Piz Piz Pi 1− wi Li (1) where Pjiz denotes the price index of exports from country j to i of type z: "ˆ Pjiz ≡ ω∈Ω ji p zji 1−σez # 1 ez 1−σ 1 = M ji1−σez p zji , dω Piz denotes the price index of type z in country i: " Piz ≡ # ∑ k ∈C αk ( Pkiz )1−σz 1 1−σ z , Pi is the aggregate price index in country i (aggregated across both types): Pi ≡ 1 1− ( Piz )1− ∑ z∈{ H,L} In equation 1, Piz Pi 1− is the share of spending on type z; α j Pjiz Piz 1−σz is the share of spending on country j varieties of type z. A typical firm from country j, therefore, sells x zji ≡ p zji q zji = X zji M ji dollars of types z. Firms are Monopolistically competitive, and charge a type-specific markup over marginal cost p zji = ez σ 1 τ ji w j = 1 + τ w ez − 1 σ η (σ z − 1) ji j > η(σ 1−1) . L Plugging the equilibrium price into the demand equation (equation 1) delivers a type-specific gravity relationship: 1 1−σz α j M jiη τ ji w j X zji = Xiz (2) 1 1−σ z η ∑k∈C αk Mki (τki wk ) Note that firms charge a higher markup on the highly differentiated (low-σ) type, i.e. 8 1 η(σ H −1) where Xiz ≡ Piz Pi 1− wi Li , is total spending on type z in country i. The above gravity formulation indicates that in the less-differentiated (high-σ) sector, L, trade shares are determined primarily on the basis of the relative price. In highly-differentiated (low-σ) sector, H, trade shares are determined primarily by National Product Quality. The number of firms entering market i from country j, M ji , is pinned down by the FREE ENTRY CONDITION: 1 M ji = wj f e " XH ji eH σ + X Lji # (3) eL σ ez − 1 = η(σ z − 1). Note that upon entry, firms collect higher profits from selling where, by assumption, σ the highly-differentiated, high-markup type, H. Therefore, countries that export relatively more of type H are represented by more firms in the global markets. Finally, BALANCED TRADE implies that wjLj = ∑ X Hji + X Lji (4) i ∈C The above equation insures that total spending in country j equals totals sales (generated income) by country j. 2.2 Four Underlying Patterns that Describe the Global Economy This section describes four underlying patterns that arise in the trade equilibrium. These underlying patterns shape the structure of production and consumption across dissimilar countries. Pattern 1. In the trade equilibrium, all else equal, countries with higher National Product Quality pay higher wages. Basically, what separates the low- and high-income countries is their National Product Quality. To demonstrate this, consider two geographically identical countries: N (North) and S (South). North is endowed with higher National Product Quality, which implies that all else equal there is more demand for Northern varieties. Balanced trade (equation 4), therefore, entails that North pays higher equilibrium wages than South: α N > α S =⇒ w N > w S Pattern 2. High-wage countries have comparative advantage in type H. To see this, note that the gravity relationship (equation 2) implies L XH ji / X ji XkiH / XkiL = τ ji w j τki wk σ L −σ H (5) The above relationship entail that high-cost countries sell relatively more of type H. Suppose North and South are located at equal distance from some country i (τ Ni = τ Si ). Equation 5 indicates that North exports relatively more of type H to i and South exports relatively more of type L H /X L XNi Ni H /X L XSi Si = wN wS 9 σ L −σ H >1 In summary, North has absolute quality-advantage in both types: α N > α S . This entails more demand for Northern varieties, and drags up their equilibrium wage: w N > w S . That being the case, North becomes comparatively disadvantaged in type L (which is price-sensitive), and has endogenously determined comparative advantage in type H.13 Comparative advantage in the unified model is similar to the Heckscher-Ohlin model in that it is endogenously determined, but different in that it is regulated by demand. Specifically demand for type H is quality-intensive, whereas demand for type L is quantity-intensive. Quality-abundant North has comparative advantage in type H, whereas labor-abundant South has comparative advantage in type L.14 Importantly, the above view of comparative advantage is more general than the classical view. In the classical view, a country has comparative advantage in a good for which the autarky relative price is lower in that country (Deardorff (1980)). Here, comparative advantage can be defined in terms of the price index, which is nominal price adjusted by quality and variety. To see this, note that the autarky relative price index of type H in country i is given by PiH !Autarky PiL 1 σ L1−1 − σ H1−1 A η = φ αi Mii where MiiA denotes the autarky number of firms in country i and φ ≡ (6) eH (σ eL −1) σ . eL (σ eH − 1 ) σ equation 6 entails that the autarky relative price index of type H is lower in the PNH PNL !Autarky < PSH Given that α N > α S , North:15 !Autarky (7) PSL Therefore, North’s comparative advantage in type H corresponds to a lower autarky relative price index of type H. Moreover, the comparative advantage of North in type H implies that (i) North is the net exporter of type H to the South, and (ii) North sells relatively more of type H and South sells relatively more of type L to some country i, which is located at equal distance from both: H XNi H XSi Pattern 3. countries: > L XNi L XSi In the TRADE EQUILIBRIUM, the price index of type H relative to type L is lower in high-income H ∂ Pi ∂αi P L i < 0. Like before, I will demonstrate this using the North-South example. Analogous to a 13 Note that the underlying assumption generating pattern 2 is that demand for the highly differentiated type is quality-intensive whereas demand for the less-differentiated type is quantity-intensive. Wage and patterns of comparative advantage are endogenously determined. 14 Note that the model predicts incomplete specialization across types. More precisely, high-income countries are net exporters of the highly-differentiated type (H), and net importers of the less-differentiated type (L). However (as opposed to neoclassical models), high-wage countries not only produce type L, but export it. This behavior is driven by “national product differentiation,” and is consistent with micro-level evidence (Schott (2004)). 15 The free entry condition implies that dMii > 0—an increase in product quality induces consumption reallocation from type L to H ∂α i and, thus, creates a greater scope for firm entry. Therefore, inequality 7 follows from the fact that " α N > α S =⇒ φ α N A MNN 1 η # 1 1 σ L −1 − σ H −1 " < φ αS 10 A MSS 1 η # 1 σ L −1 < 1 1 σ L −1 − σ H −1 1 σ H −1 and α N > α S : (two-country) Neoclassical trade model, if North and South (countries N and S) engage in trade, the relative price of type H rises in North and Falls in South. However, due to trade costs, prices are not equalized across countries. Specifically, the relative price of type H remains lower in North even after trade: PNH PNL !Autarky PH PH < NL < SL < PN PS PSH !Autarky PSL The above result follows from the fact that the price index under trade is a weighted CES average across all international prices, with more weight put on the domestic price.16 Pattern 4. All else equal, high-income countries consume relatively more of the highly differentiated, high markup type H. In the context of the example used thus far, North (N) spends relatively more on type H, than the South (S): H XSH XN > L XN XSL The above result is a direct consequence of pattern 3. The relative price index of type H is lower in the North. Hence, the relative consumption of type H is higher. This result is novel and emerges despite the fact that preferences are homothetic and independent of per capita income (existing theories generate consumption disparity across nations by assuming non-homotheticity). Moreover, this pattern can be generalized as follows: if type H and L exhibit some degree of substitutability and trade is costly, countries consume relatively more of the locally competitive type. I refer to this pattern as the Home Production Effect on local consumption. It is the opposite of the Home Market Effect highlighted by Krugman (1980). The Home Market Effect states that local demand dictates patterns of local production. The Home Production Effect states that, when trade is costly, local production determines local consumption. 2.3 The Three Stylized Facts Concerning the Composition of Trade The four underlying patterns, highlighted in section 2.2, determine the composition of global trade. The predicted composition collectively explains three stylized facts that are beyond the scope of pure gravity models. Extensions to gravity models have been proposed to confront each fact individually. However, the present framework is the first to collectively explain all three facts. Income per capita × trade-to-GDP ratios. Rich countries have systematically higher trade-to-GDP ratios because they produce and consume relatively more of type H. Type H goods is highly-differentiated and σ −1 subject to a lower effective trade cost: τ jiH τ σjiL −1 . Let λiiz ≡ Xiiz Xiz , denote share of domestic expenditure 16 Under free trade (τ = 1, ∀i, j), prices equalize in North and South, since they are geographically identical and have access to the ji same set of varieties: !Free Trade !Free Trade PSH PNH = PNL PSL 11 on type z. The trade-to-GDP ratio of country i can be written as Trade GDP i XH XL i i + 1 − λiiH = 1 − λiiL Xi Xi In the South, consumption is dominated by type L: XSL XS ≈ 1. The effective trade costs, however, are sizable in type L entailing negligible import flows Trade GDP S L ≈0 ≈ 1 − λ SS In the North, consumption is dominated by type H: L XN XN ≈ 1. The effective trade costs, however, are negligi- ble in type L sizable negligible import flows Trade GDP ≈ N H 1 − λ NN 1+ η1 αN ≈ 1− 1+ η1 ∑k αk α 1+ 1 η ≈ α Nj , when σ H approaches unity. The relationships above, indicate that the trade-to-GDP of the (low-wage) South is negligible relative to the (high-wage) North. This result offers an important contribution to the existing literature. Existing studies either exogenously assume that rich countries face lower trade costs (Waugh (2010)), or assume that rich countries consume more of the highly-tradable types with non-homotheticity (Fieler (2011); Caron et al. (2014)). In the present model, rich countries specialize in the highly-tradeable type in equilibrium, and also consume relatively more of the highly-tradable type by choice rather than assumption. The above result follows from the fact that XH jN H XNN Income per capita × the price composition of exports. In the UNIFIED MODEL, two factors contribute to the higher price of exports from high-income countries. First, high-income countries sell each type of good (H and L) at a higher equilibrium price. This is due to the higher National Product Quality in high-income countries: α N > α S ; τ Ni = τ Si =⇒ H p Ni H p Si = p LNi p LSi = wi >1 wS This channel corresponds to quality-differentiation, and presents a standard explanation, widely investigated in the literature (Schott (2004); Hallak and Schott (2011)). The second channel, however, is novel and corresponds to a composition effect. High-income countries export relatively more of the high-markup type H. That is to say, the North exports relatively more of the highly-differentiated, high-markup type H, whereas the South exports relatively more of the less-differentiated, low-markup type L. To show this, not that the average price of exports from country j to i is p ji = XH ji X ji X Lji ! pH ji + X ji 12 ! p Lji ; j = N, S XH L Ni Type H exhibits a higher price (p H > ji > p ji ), and North (N) sells relatively more of type H ( X Ni H XSi XSi ), which implies: p Ni > p Si . Generally speaking, all else the equal, the share of the highly-differentiated, high-price type (H) increases in a nation’s export-mix, the higher the National Product Quality. This entails higher export price from rich countries:17 H ∂p ji ∂ X ji > 0 =⇒ >0 ∂α j X Lji ∂α j Distance × the price composition of exports According to the gravity relationship trade volumes decrease with bilateral distance. However, when one decomposes volume into quantity and price, exportquantity decreases with distance whereas export-price increases (Bernard, Jensen, Redding, and Schott (2007)). The observation that export prices increase with distance is generally labeled as THE WASHING TON A PPLES E FFECT. Surprisingly, despite being one of most-documented and robust patterns of trade, THE WASHINGTON A PPLES EFFECT is inconsistent with mainstream gravity models. A unique future of the unified model is accommodating THE WASHINGTON A PPLES EFFECT. The unified theory offers a novel explanation for the effect, which (unlike standard explanations) is consistent iceberg trade costs.18 Equation 5 implies that countries export relatively more of the highly-differentiated, high-markup-type (H) when facing larger iceberg trade costs. More specifically, all else the same, higher trade costs increase the demand for type H relative to L: H ∂p ji ∂ X ji >0 > 0 =⇒ L ∂τ ji X ji ∂τ ji The above effect is driven by the higher price elasticity of type L. Demand for type L is extremely pricesensitive, which puts the high-cost exporters from distant countries at a disadvantage. As a result, distant trading partner exchange relatively less of type L, and relatively more of type H.1920 17 For example, consider car exports from Korea and Germany. Suppose there are two types of cars: Luxury (high-markup) cars, and Economy (low-markup) cars. The present model predicts that Germany sells both types of cars at a higher price point due to its higher National Product Quality. Additionally, Germany sells relatively more luxury cars and Korea sells relatively more Economy cars. This additional composition effect contributes to Germany’s higher export prices relative to Korea. 18 The standard explanation is founded on additive trade costs, and is due to Alchian and Allen (1983). 19 Additionally, firms collect higher profits from exporting type H (since type H offers a high markup). Introducing fixed exporting costs would, therefore, introduce an additional channel that contributes to the “Washington Apples” effect. That is to say, when incurring fixed costs, high-cost exporters would generate profits only from selling the type that offers high variable profits. Therefore, firms export only the high-profit and high-price type, H, to faraway locations. 20 A real world example that corresponds to this effect, is car exports from Germany. Germany exports relatively more Luxury (high-markup) cars to the US and relatively more Economy (low-markup) cars to France. 13 2.4 A Special Case: T HE P URE G RAVITY M ODEL If both types of goods are identical (σ H = σ L = σ ), the present model reduces to a (one-sector) P URE GRAVITY MODEL .21 The gravity equation, therefore, becomes 1 α j M jiη τ ji w j X ji = 1−σ 1 η ∑k∈C αk Mki (τki wk ) 1−σ Xi (8) The pure gravity model, characterized by equation 8 , nests THE A RMINGTON MODEL. If firms are perfectly competitive (η → ∞, and f e = 0), equation 8 reduces to the standard Armington gravity equation: X ji = α j τ ji w j 1−σ ∑k∈C αk (τki wk ) 1−σ Xi Contrary to the unified model, the pure gravity model does not systematically characterize the composition of trade. As a result, the pure gravity model generates three counter-factual patterns: First, in THE PURE GRAVITY MODEL , high-income countries have have lower trade-to-GDP ratios. High-income countries have a lower equilibrium effective wage (wσi −1 /αi ), which makes them globally more competitive, but also less likely to import. Second, in the gravity model, aggregate export flows from all countries are counterfactually subject to the same trade elasticity σ. Third, bilateral distance has no systematic effect on export prices in the gravity model. In the pure gravity model, countries sell the same type of good at the same f.o.b. price across all locations. Additionally, in the gravity model, higher income has no compositional effect on export prices, which is inconsistent with micro-level evidence.22 3 Mapping the Model to Data This section estimates the structural parameters of the model by fitting it to data on bilateral trade volumes and per capita income. The UNIFIED MODEL matches the trade volumes remarkably better than the PURE GRAVITY MODEL . Additionally, in contrast to the gravity model, the unified model delivers factual out- of-sample predictions regarding the price of aggregate tradeables. The improved explanatory power of the unified model stems from matching both the composition and the volume of trade. To quantify the importance of the composition margin, I perform a counter-factual analysis and estimate the gains from trade within both models (the unified model and the pure gravity model). The results offer unique insight into the size and distribution of the gains from trade across dissimilar countries. 21 Another special case rises when η = 1. In this case, National Product Differentiation is eliminated, and the only remaining force behind trade is comparative advantage across types. Suppose there are a continuum of types, z ∈ [0, 1], and two countries: North (N) and (South). In that case, the model becomes analogue to DFS. Specifically, let North have a higher national product quality: µ N > µ S . There exist two cut-offs, σ and σ, such that North is the sole producer (and exporter) of type z if σ z < σ; South is the sole producer (and exporter) if σ z > σ; and type z is not traded if σ < σ z < σ . 22 If one adopts the Ricardian framework to generate the standard gravity model (e.g. Eaton and Kortum (2002); Fieler (2011)), the predicted export prices would be counter-factually lower from rich countries. Waugh (2010) proposes asymmetric trade costs to overcome this counterfactual aspect of the Ricardian gravity model. 14 Data . I use data on bilateral merchandise trade flows in 2000 from the U.N. Comtrade database (Comtrade (2010)). The data on population and GDP, and the price of tradeables are from the World Bank database (World-Bank (2012)). My sample consists of the 100 largest economies (in terms of real GDP), which account for more than 95% of the world trade in 2000. Data corresponding to country pairs–distance, common official language, and borders–are compiled by Mayer and Zignago (2011). 3.1 Estimation Strategy The section presents the estimation procedure and addressee identification issues. Equation 2 characterizes bilateral trade flows for each type of good. I can, therefore, calculate total flows from country j to i as L X ji = X H ji + X ji (9) where X H and X Lji are given by equation 2. Aggregate trade flows are a function of the number of (exporting) ji firms Mi j i, j∈C , population { Li }i∈C , wage {wi }i∈C , National Product Quality α ≡ {αi }i∈C , iceberg trade costs T ≡ τ ji j,i∈C , and demand parameters σ L , σ H , and η.23 I take populations Li and wage wi from the data, solve for the equilibrium number of firms M ji , and estimate αi , τ ji , σ L , σ H , , and η. The procedure is the following: i. I parametrize the iceberg trade costs: τ ji = 1 + κconst + κdist dist ji κborderκlangκagreement where dist ji is the distance (in thousands of kilometers) between countries j and i. κ border , is one if countries do not share a border, and an estimated parameter otherwise. For example, if κ border is, say, 0.9, sharing a border reduces trade costs by 10%. Similarly, κAgreement and κlang are one if a country pair n do not have a trade agreementoor a common-language, and estimated otherwise. Hereafter, κ ≡ κborder , κlang , κagreement , κconst , κdist denotes to the vector of parameters corresponding to trade costs. For any given κ, and data on distance, trade agreements and borders, I can construct a matrix of iceberg trade costs. ii. Given parameters κ, α, σ L , σ H , η; and data (D) on the wages, population, distance, trade agreements, common languages and borders I can solve for the mass of firms using the free entry condition (equation 3): M ji = M ji (κ, α, σ L , σ H , η; D), i, j ∈ C iii. Given M ≡ { M ji }i, j∈C from the previous step, parameters κ, σ L , σ H , η, and data (D), I resolve for a vector of National Product Qualities, α, that satisfy the trade balance condition (equation 4): α j = α j (M, κ, σ L , σ H , η; D), j∈C 23 The entry cost parameter, f e , governs the scale of entry and is normalized to one. The normalization does not affect trade flows , but normalizes the mass of firms in each markets. Putting it differently, f e cannot be identified from trade flows; it can be identified with data on the number of firms. 15 More precisely, α j is chosen so that the market clearing wage equals data on GDP per capita. To this end, I solve for the National Product Qualities that ensure balanced trade given the observed countryspecific wages. iv. For any set of parameters {κ, σ L , σ H , η}, and data D, I iterate over steps 2 and 3 to find an implicit solution for α j and M ji . Using the implicit solution, I calculate bilateral trade flows X ji from equation 9. Let λ ji = X ji Xi denote the trade share of country j in i. The gravity equation 2 in stochastic form becomes λ ji = g(κ, σ L , σ H , η; D) + ε ji (10) The above equation indicates that trade shares (λ ji ) are a function of data D and the 8 parameters to be n o estimated κborder , κlang , κagreement , κconst , κdist , σ L , σ H , η , plus the error term ε ji . I estimate equation 2 by minimizing the residual sum of squares (Non-linear Least Squares (NLLS)).24 Here, I explain how of the eso n trade flow data allows for the identification timated parameters: κ, σ L , σ H , η. The vector κ = κborder , κlang , κagreement , κconst , κdist determines the size Identification of parameters. of the iceberg trade costs. Specifically, κ1 governs trade-to-GDP across all countries. κ2 and κ3 govern the effect of bilateral distance on bilateral trade flows. η has a very different effect from iceberg trade costs (and parameter κ1 , in particular). A higher κ1 reduces trade-to-GDP for all countries, whereas a lower η makes imports more concentrated. As η approaches 1, countries import each type from the most competitive supplier. As η becomes large, imports are diversified. As in standard gravity models, the magnitude of trade elasticities (σ H and σ L ) are not jointly identified. However, if I set σ L = 6, I can separately identify σ H . The relative magnitude of σ L to σ H governs the differential effects of distance on export flows from rich and poor countries. Parameter is the elasticity of substitution across types, which determines relative spending on each type. That being the case, governs the size of the Home Production Effect on local consumption, which gives rise to differences in trade-to-GDP ratios across rich and poor countries. 3.2 Results The estimation results are presented in table 1. The first column reports the estimation results for the UNI FIED MODEL . Column two reports estimation results corresponding to the PURE GRAVITY MODEL (described in section 2.4). Column three reports estimation results for the A RMINGTON MODEL—a special case of the general pure model. When estimating the unified model I normalize σ L (the elasticity of substitution for the type L) to 6. When estimating the pure and restricted gravity models, I normalize the elasticity to 4.6: the average of the estimated σ H and σ L = 6 from the unified model. This way, the trade elasticity in the gravity model equals the average elasticity in the unified model. This, makes welfare comparison between the two models plausible. In both the unified model and the pure gravity model, countries diversify their imports due to National Product Differentiation. All else equal, in the unified model countries have more incentive to concentrate 24 Anderson and Van Wincoop (2003) and Fieler (2011) also estimated a general equilibrium, multi-country model with NLLS by simulating the whole economy and solving for endogenous variables. Both papers offer an extensive discussion on the unbiasedness of the estimator. 16 their imports towards dissimilar partners. This is motivated by comparative advantage across types. Therefore, to match the observed levels of trade diversification, the unified model estimates a greater scope for National Product Differentiation. In the Armington (restricted gravity) model, the scope for National Product Differentiation is assumed to be complete, i.e. η → ∞. The only force that prevents countries from fullydiversifying across national varieties is, therefore, the distance effect. That being the case, the Armington model over-estimates the distance elasticity to match the level of trade diversification observed in the data. As illustrated in table 1, the unified model offers remarkable improvement over the pure gravity model in matching trade flows across dissimilar countries. Specifically, the unified model has an R2 that is 43 percent higher than pure gravity model (table 1) . The improved fit of the unified model comes from matching two quantitatively important margins: (i) the lower trade-to-GDP ratios of poor countries and (ii) the higher distance elasticity of exports from poor countries. Parameters U NIFIED MODEL P URE GRAVITY R ESTRICTED GRAVITY (A RMINGTON MODEL ) σ L (Normalized) 6 4.6 4.6 σH 3.27 (0.025) ... ... 2.78 (0.011) ... ... η 3.16 (0.024) 2.63 (0.019) ... κconst 2.16 (0.017) 1.96 (0.020) 0.96 (0.027) κdist 0.11 (0.002) 0.19 (0.003) 0.83 (0.006) κborder 0.57 (0.01) 0.69 (0.013) 0.27 (0.009) κlang 0.87 (0.007) 0.72 (0.006) 0.37 (0.005) κagreement 0.71 (0.013) 0.80 (0.013) 1.17 (0.011) Goodness of fit (R-squared) 0.43 0.30 0.24 Table 1: Estimation Results – Standard error are reported in parenthesis. 17 Income per capita and trade-to-GDP ratios. Figure 2 displays the relationship between trade-to-GDP and per capita income in the data, and compares it to the predicted values from the unified model and the pure gravity model. The gravity model counter-factually predicts that trade-to-GDP drops with income per capita. This feature of the gravity model makes it inapt for analyzing trade among rich and poor countries— especially given that trade-to-GDP ratios are the metric that govern the gains from trade. The unified model, on the other hand, correctly predicts the positive relationship between trade-to-GDP and per capita income. Note that the unified model delivers this pattern under homothetic preferences, whereas alternative theories rely on both non-homotheticity and sectoral heterogeneity. That said, the main advantage of the unified theory over existing alternatives is reconciling higher trade-to-GDP ratios with higher aggregate export prices in rich countries. Income per capita and trade elasticities. Figure 3 plots the normalized export flows X ji Xi X j against bilateral distance dist ji . Exporters are divided in to two groups: North and South. North consists of the richest 50 countries, and South is the poorest 50. In the data, export flows from the North are less sensitive to distance compared to export flows from the South.25 The unified model correctly captures this patterns. The pure gravity model, in contrast, counter-factually predicts similar elasticities for North and South. This result points to another key contribution of this paper. In the unified model trade elasticities are country-specific and endogenously determined by sectoral specialization. As the estimation results indicate, this feature of the unified model is qualitatively important. 3.3 Out-of-sample performance When estimating the model, I exclusively targeted trade volumes. One of the main merits of the unified model, however, is collectively explaining patterns regarding the price of tradeables. This section demonstrates the unified model’s performance in delivering such out-of-sample patterns. Income per capita and the price composition of exports. High-income countries export higher price goods within narrowly defined categories and, therefore, have a higher aggregate export-prices. This observation is partially due to the distinct composition of exports from rich countries (Schott (2004)). Workhorse gravity models that allow for international productivity differences (e.g. Chaney (2008); Eaton and Kortum (2002)), counterfactually predict that high-income countries have lower export prices. The Armington gravity model asserts that export prices are determined solely by exporter-wage. None of workhorse gravity models characterize a systematic relationship between exporter-wage and the composition of trade. In the unified model, however, export prices are determined jointly by both exporter-wage and the composition of exports. High-income countries have higher export prices due to: (1) their higher National Product Quality, 25 To formally illustrate the (mediation) effect of income per worker on trade elasticities, I can run a conventional gravity regression on my sample of 100 countries. Specifically, I allow for interaction between bilateral distance and the exporter’s income per worker: ! ln X ji = −3.26 + 0.20 ln w j (0.15) (0.02) ln DIST ji + S j + Mi + ji where S j and Mi are exporter and importer fixed effects. The robust standard errors are reported in the parenthesis, and the R2 is 0.47. The results confirm that export flows from rich countries are significantly less sensitive to distance. 18 which is reflected in their higher wage, and (2) their markup-intensive exports. The latter effect is novel and purely compositional. Figure 4 illustrates the estimated effect of export composition on export prices in the unified model. T HE WASHINGTON A PPLES EFFECT. Countries export higher-price goods to far-way markets. Workhorse gravity models predict the opposite pattern. Specifically, in heterogeneous gravity models (e.g. Chaney (2008); Eaton and Kortum (2002)) bilateral distance lowers the f.o.b. price of exports. In homogenous gravity models (e.g. the Armington model), f.o.b. export prices are the same across all the export destinations. In the present model, bilateral distance determines the composition of exports. Specifically, when facing higher trade costs, exporter sell relatively more of the highly-differentiated, high-markup type H. This gives rise to THE WASHINGTON A PPLES EFFECT in the presence of ad-valorem trade costs. Figure 5 illustrates this result; the model predicts that aggregate exports prices from Germany and the US significantly increases with distance to a given market. 4 4.1 The Gains from Trade The realized gains from trade In the pure gravity model, when η is sufficiently large, the gains from trade relative to autarky are determined solely by the intensity of trade. Specifically, Let λii denote the share of domestic consumption in the GDP (one minus trade-to-GDP ratio) of country i. The gains from trade relative to autarky in the gravity model are given by − 1e Gainsi = λii where e = σ − 1 is the trade elasticity, and common across countries. Arkolakis et al. (2012) show that the the above equation characterizes the gains from trade in all the workhorse gravity models. Unlike gravity models, in the unified model the gains from trade not only depend on the intensity of trade, but also the composition of trade. Specifically, trade elasticities are endogenously determined by the composition of a nations’ imports, and are country-specific. When η is sufficiently large, the gains from trade in the unified model are given by −1 − −1 −1 1 − σ −1 σ L −1 H H Gainsi = µi λii + (1 − µi ) λiiL −1 σ −1 where µi ≡ αi H (11) −1 −1 σ −1 σ −1 / αi H + αi L is the autarky share of expenditure on type H in country i. Equation 11 indicates that the gains from trade in the unified model are a weighted average of gains across the two sectors. The gains form trade are systematically larger in the highly differentiated sector, H. The overall − 1 gains from trade are, therefore, dominated by the magnitude of the term µi λiiH σ H −1 . In the unified model the gains from trade are sizable for both rich and poor countries. The gains are sizable for rich countries as they consume relatively more of type H, which corresponds to a high µi . That being 19 the case, rich countries have higher overall trade-to-GDP ratios, which results in sizable gains. For poor and remote countries, the gains are sizable as their imports are concentrated on the highly-differentiated type. This corresponds to a high λiiH λiiL and, therefore, sizable gains. Importantly, the gravity models systematically understate the gains from trade compared to the unified model. For rich countries the gravity model systematically under-states the gains, since it counterfactually asserts that rich countries have lower trade-to-GDP ratios. The gravity model systematically understates the gains for poor countries as it forces their imports to have the same elasticity as rich countries. In general, the understatement of the gains from trade in gravity models are due to the absence of international specialization.26 Specifically, gravity models overlook the gains that arise due to systematic differences in production and consumption composition across countries.27 To quantify the importance of the composition margin, I estimate the gains from trade in the unified model and compare them with the gains implied by the gravity model. To this end, I compare the factual real wage with the counter-factual autarky real wage in both models. I solve for the counter-factual real wages by resolving the general equilibrium with no trade. The estimated gains are presented in figure 6. A summary of the estimated gains is reported in table 2. Expectedly, the gains from trade are about two-times larger in the unified model and more unequally distributed across countries. Simply put, the composition of foreign trade plays a central role in determining both the size and the distribution of the gains across nations. The average gains from trade relative to autarky The coefficient of variation of the gains (across countries) T HE UNIFIED MODEL 4.45 (per cent) 1.10 T HE PURE GRAVITY MODEL 2.38 (per cent) 0.84 Table 2: Summary statistics of the estimated gains from trade relative to autarky. The gains from trade correspond to percentage changes in real wage when moving from the counter-factual autarky equilibrium to the factual trade equilibrium. 4.2 The prospective gains from trade The previous section estimated the realized gains from trade by comparing the factual real wage with the autarky real wage. In this section, I ask a more policy-relevant question: how large are the prospective gains from lowering the trade costs by 10%? To address this question, I first perform a counterfactual analysis to estimated the prospective gains. I then compare the prospective gains implied by the unified model with those implied by the pure gravity model. Two systematic patterns emerge: 26 The unified model offers two welfare-improving channels: First, liberalizing trade enables consumers to add more national varieties to their consumption bundle (re-allocation of consumption). This channel prevail in any model with “national product differentiation.” Second, opening to trade enables countries to reallocate production from their less competitive sector to the more competitive one. As a result of systematic specialization global production becomes more efficient. This additional channel, which corresponds to systematic specialization, is missing in gravity models and explains the larger gains from trade in the unified model. 27 Surprisingly, Neoclassical trade models focus exclusively on characterizing the composition of foreign trade. 20 i. The unified model predicts that the prospective gains from trade are substantially larger for poor countries. The gravity model predicts a weak relationship between income per capita and the prospective gains. (figure 7). ii. The gravity model systematically understates the prospective gains for geographically remote countries (figure 8). The above patterns indicate that at the prevailing levels of globalization, poor and remote countries are the main beneficiaries from further globalization. Given the existing impediments to trade, poor and remote countries are predominantly importing the highly-differentiated type. Foreign varieties of the highlydifferentiated type are not easily substituted with domestic counter-parts. That being the case, liberalizing trade furthermore allows these countries to import more of the highly-differentiated type, which would improve their welfare dramatically. In the gravity model, such patterns are absent since all countries import the same type of good. This result could have important applications for a vibrant literature that studies trade negotiation between dissimilar countries. 5 Conclusion This paper develops a unified framework that combines within-product trade in differentiated goods with trade resulting from across-product specialization. The driving force behind across-product specialization is novel and collectively delivers three principle facts about the composition of foreign trade. While these principle facts have been approached individually by the previous literature, the unified framework is the first to collectively explains all three facts, while retaining the standard assumptions that ensure tractability. Specifically, the unified theory (i) explains the effect of income per capita on the composition of imports and exports assuming standard homothetic preferences, and (ii) explains the effect of distance on the composition of trade assuming standard iceberg trade costs. That being the case, the unified model offers a tractable framework that, unlike standard gravity models, permits the analysis of trade between vastly dissimilar countries (e.g. trade between developed and developing countries). I estimate the unified model to study the welfare consequences of trade across rich and poor countries. Allowing for systematic across-product specialization magnifies the gains from trade for all countries. Specifically, the gains from trade in the unified model are two-times larger than a standard gravity model that only permits within-product trade. Moreover, the prospective gains from further liberalization of trade depend crucially on the characteristics of a country and the composition of its imports. Relative to the standard gravity model, the prospective gains from trade in the unified model are pro-poor and remote countries. This finding could have substantial implications for a vibrant literature that studies international trade agreements. Two aspects of the unified model merit further research. In the unified model National Product Quality determines the composition a nation’s trade. The model, however, is mute on the determinants of National Product Quality. One could extend the unified model so that National Product Quality is endogenously determined by the capital- or skill-abundance of a country. Second, the unified model can be extended to allow 21 for intermediate trade and multi-national production. Such extensions could provide a tractable framework for studying those phenomena across dissimilar countries. 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World Bank-free PDF. 24 TZA UGA LUX −5 0 USA JPN ISL CHE QAT NOR DNK HKG IRL AUT DEU BEL SWE GBR FRA NLD CAN SGP FIN ITA ARE AUS ISR KWT ESP TWN CYP BHR KOR PRTNZL GRC SVN ARG SAU URY OMN LBY TTO MEX CHL CZE BRA VEN POL HUN LBN CRI HRV BWA MYS SVK LVA ZAF TUR LTU JAM DOM PER COL THA SLV TUN PRY RUS DZA JOR IRN ROM BGR EGY ECU BLR KAZ CHN BOL MAR SYR YUG PHL IDN LKA CMR AGO UKR ZWE IND PAK CIV UZB YEM VNM KEN BGD NGA SDN −10 Log( relative production of type H ) 0 −2 CMR AGO CIVUKR ZWE UZB YEM PAK IND KEN VNM NGA SDN BGD −4 Log( GDP per worker (US=1) ) Pattern 2 LUX NORJPN USA CHE ISL DNK QAT SWE HKG IRL NLD AUT GBR SGP DEU FIN BEL CAN ARE FRA AUS ISR ITA KWT TWN ESP CYPNZL BHR PRTKOR GRC SVN OMN SAU ARG LBY URY TTO CZEMEX CHL VEN HUN LBN POL CRI HRV MYS BRA SVK BWA LVA LTU JAM TUR ZAF DOM SLV PER COL TUN THA DZA JOR RUS ROM BGR IRN EGY PRY ECU BLR KAZ MAR SYR YUG BOL PHL LKAIDN CHN 5 Pattern 1 TZA UGA ETH −6 −15 ETH −20 −10 0 −6 −2 0 Pattern3 Pattern 4 .5 SAU BHR NZL SVN CYP GRC KOR KWT PRT TWN ISR ARE SGP QAT ISL ESP AUSHKG FIN IRL AUT LUX ITABEL SWE NLD DNK NOR FRA GBR CAN CHE DEU JPN 0 DEU CHE CAN GBR FRA NOR DNK NLD SWE ITABEL LUX AUT IRL FIN AUSHKG −1 1 MEX JPN MEX −2 CZE USA ETH −3 1.5 ETH PER IDN BOL PRY COL ZAF ECU THA IND BGD BRA CHL VNM CHN AGO LKA ZWE BWA URY PHL SLV PAK IRN KAZ TZA NGA CRI DOM KEN UZB UGA SDN CIV TUR MYS VEN YEM EGY CMR ROM UKR SYR MAR RUS DZA JAM JOR YUGBLRBGR LTU TUN LVAHRV LBY TTO LBN ARG HUN SVKPOL OMN Log( relative consumption of type H ) 1 Log( GDP per worker (US=1) ) 0 Log( relative price index of type H ) −4 Log( National Product Quality ) 2 −30 USA −6 −4 −2 0 −6 Log( GDP per worker (US=1) ) ESP ISL SGP QAT ARE ISR TWN PRT KWT KOR GRC SVN CYP NZL SAU BHR CZE OMN POL SVKLBN HUN TTO ARG LBY HRV LVA TUN LTU YUGBLRBGR JOR RUS JAM DZA MAR ROM SYR UKR CMR EGY YEM TUR MYS VEN CIV UGA SDN KEN UZB DOM CRI TZA NGA PAK PHLKAZ IRN SLV URY BWA ZWE AGO LKA CHN VNM BRA CHL BGD IND ECU THA COL ZAF IDN BOL PRY PER −4 −2 Log( GDP per worker (US=1) ) Figure 1: The four underlying patterns that characterize the global economy: (i) countries with high national product quality, pay higher wages; (ii) high-wage countries relatively more competitive in production of type H, and specialize in the production of type H (type H is the highly differentiated, high markup type); (iii) due to trade costs, the relative price of type H is lower in high-income countries; (vi) high-income countries spend relatively more on type H. 25 0 Data SGP 0 MYS PHL BLR AGO BEL IRL HUN THA CZE TWN SVNBHR ARE NLD LUX QAT OMN SAU KWT CAN CHE SWE AUT LKA KOR FIN ROM IDN NGA YEM HRV MEX ECU JOR MAR CIV PRT DOM JAM YUG NZL ISR DEU DNK ISL NOR RUS CHN CYP LBY DZA CHL SYRPRY BWAPOL ZAF FRA IRN ESP GBR SLV TUR LBN ZWE ITA CMR VEN KEN GRC AUS BOL COL BGD URY SDN PAK UZB PER VNM −1 UKR −2 Log( trade−to−GDP ratio ) HKG SVK ETH BGR TUN KAZ LTU CRI LVA TTO TZA UGA EGY BRA USA JPN ARG −3 IND −6 −4 −2 0 Log( GDP per worker: US=1 ) 0 The Unified model −1 ISL QAT IRL BEL AUT DNK CHE FIN NOR CAN HKG NLD SWE SGP −2 PRY ETH UGA JOR YUGBLRBGR BOL SYR TUN KAZ SDN KENYEM UKR ZWE CMR TZA −3 Log( trade−to−GDP ) LUX ARE URY SVN CYP KWTFRA BHR PRT ISR DEU LVA MEX LTU GRC ESP ITA SVK CZE OMN MYS LBN HRV BWA GBR LBY HUN TTO JAM POL MAR ROM DZA RUS ECU EGY DOM SLV CRI IRN COL PER TUR VEN THA CHL UZB VNM PAK CIV AGO NGA BGD LKAPHL CHN IDN IND SAU ARG NZL TWN KOR ZAF AUS USA BRA −4 JPN −6 −4 −2 0 Log( GDP per worker (US=1) ) 0 The Pure Gravity Model −2 ETH PRY JOR BEL YUG LVA TUN BOL LTU LBN URY SVNBHR YEM IRLQAT BLRBGR AUT CMR SYR CYP JAM SVK BWA ZWE HRV TTO OMN KEN ISLCHE LBY TZA MAR UKR ECU DZA KAZ FIN CZE KWT CAN CIV HUN SLV DNK ROM UZB PAK CRI PRT DOM NLD ARE GRC AGO MYS SWE EGY SGP VNM PER NGA POL ISRFRA COL HKG LKA DEU SAU CHL NOR PHL BGD ESP IRN VEN RUS TUR ITA ARG GBR THA MEX IND UGA SDN ZAF IDN −4 Log( trade−to−GDP ) LUX CHN TWN NZL BRA KOR USA AUS −6 JPN −6 −4 −2 0 Log( GDP per worker (US=1) ) Figure 2: Trade-to-GDP ratio increases with GDP per capita in the data. The unified model captures this pattern, whereas the gravity model does not. 26 Data −10 −15 X ln X i Xi j j −20 −25 North South South North −30 −35 −3 −2 −1 0 1 2 3 1 2 3 1 2 3 ln( d i s t i j) The unified model −12 −14 −18 X ln X i Xi j j −16 −20 −22 North South South North −24 −26 −3 −2 −1 0 ln( d i s t i j) The Gravity model −15 −20 X ln X i Xi j j −25 −30 −35 North South South North −40 −45 −3 −2 −1 0 ln( d i s t i j) X Figure 3: Normalized export flows ( X j Xji i ) from the North (the richest 50 countries) are less elastic to distance than export flows of the South (the poorest 50 countries). The unified model captures this pattern, whereas the gravity model does not. 27 1.14 1.12 CYP CAN BEL FRA ITADEU BHR KOR 1.1 ESP PRT ARG GRC SVN OMN SAU 1.08 URY TTO CHL VEN LBY CRI CZE HUNMEX BRA LBN BWA POL HRV ZAF JAM SVK LVA LTUMYS TUR DOM SLV PER COL THA TUN DZA ROM IRN JOR ECU BGR PRY EGY RUS KAZ BLR BOL MAR PHL YUG SYR LKA CHN IDN AGO CMR ZWE CIV UKR UZB PAK YEM IND NGA VNM KEN UGA TZA BGD SDN ETH 1.06 Export price (net of wage and trade cost) JPN ISL NOR QAT LUX AUSHKG SGP CHE USA ARE DNK ISR SWE IRL NZL KWT GBR TWN NLD FIN AUT −6 −4 −2 0 Log(GDP per worker (US=1) ) Figure 4: The unified model predicts that export prices (net of trade costs and wage) strongly increase with GDP per capita. The above figure displays the compositional effect of GDP per capita on export prices in the (estimated) unified model. Germany’s exports .76 1.14 U.S. exports QAT NOR 1.13 LUX GBR CZE QAT NOR SWE FIN FRA AUS NZL IRL ISL NLD CHE BEL AUT DNK .72 ISL BRA IND CHN IDN ARG ZAF CHL THA COL VEN MEX PPER HL KOR MYS PAK BGD URY TUR VNM RUS TWN ECU PRY EGY IRNSAU NGAUSA DOM LKA C RIBOL SLV JPN KAZ KEN DZA MAR ZWE BWA AGO TZA ROM HKG UZB CAN UKR LBY SGP SDN HUN CIV CMR JAM SYR ETH YEM UGA OMN TTO TUN LBN BGR ESP ISR BLR HRV SVK POLITALTU JOR KWTARE GRC YUG LVA PRT SVN BHR CYP .75 MEX TTO .74 JAM Aggregate price of German exports 1.135 CRI SLV IRL 1.125 Aggregate price of US exports DOM .73 CHN BRA IDN IND THA ARGIRNKOR ZAF TUR MYS RUS CHL PHL VNM EGYSAU PAKBGD PERPOL LKA URY KAZ TWN DZA NGA ESP ROM ITA JPN AUS UKR GRC PRY DEU UZB HUN SDN AGO MAR BOL ECU FRA CZELBY SYR YEM KEN OMN NZL ZWE LBN TZA TUN PRT BWA CIV BGR HRV BLR GBR SVK HKG SGP ETH JOR LTU CMR UGA ARE YUG ISR KWT NLDLVA AUT BEL SVN BHR SWE FIN CYP CHE DNK VEN COL LUX CAN 6 7 8 9 10 5 6 7 8 Log( distance to Germany ) Log( distance to the US ) Figure 5: The unified model delivers the “Washington Apples” effect: export prices (net of trade costs) increase with bilateral distance. 28 9 10 JPN USA BRA ARG AUS KOR CHL ZAF TWN VEN NZL IDN PER COL THA IND CHN LKA BGD CRI ECU PHL SAU IRN AGO TUR SLV VNM DOM NGA PAK BWA TZA ZWE EGY CIV GBR UZB BOL KAZ KEN LBY MYS ROM CMR YEM DZA RUS MAR URY POL TTO JAM UKR OMN ETH ISR HUN UGA SDN ITA SYR HRV LBN TUN ESP BGR SGP BLR LTU DEU ARE YUG KWT LVA HKG GRC JOR SVK CZE BHR PRY FRA PRT CYP SVN MEX NOR SWE NLD FIN CAN CHE DNK AUT QAT BEL IRL ISL LUX Th e u n ified m odel Th e gen er a l gr a vit y m odel 0 10 20 30 40 50 Th e ga in s fr om t r a de r ela t ive t o a u t a r ky Figure 6: The estimated gains from trade relative to autarky. The gains from trade are both systematically larger and more dispersed in UNIFIED MODEL relative to the PURE GRAVITY MODEL. 29 The Unified model PRY JOR CZE YUGBLR JAM LVA POL LTU SYR BGRTUN UGA SVK BOL YEMUKR LBN HRV DZA MAR ROM CMR PRT KEN KAZEGY HUN SVN RUS DOM UZB ZWE TZA NGA PAK TTO SLV TUR URY PHL ECU VNM CIV GRC MYS BWA IRN COL CRI BGDIND AGO LKA LBY THA CHN OMN PER IDN ESP ZAF VEN SAU BRA CHL SDN 5 ETH ARG 0 The prospective gains from trade 10 MEX CAN BEL IRL ISL AUT QAT FIN DNK ITAFRA NLD DEU KOR CHE NZL BHR GBR TWN CYP SWE AUS JPN USA ISR KWT NOR ARE −5 SGP HKG −6 −4 −2 0 Log( GDP per worker (US=1) ) 15 The Pure Gravity Model 10 JOR BEL BOL YUG UGA SDN 5 ETH TZA 0 The prospective gains from trade PRY −6 YEM CMR ZWE TUN BLRBGR SYR LVA LTU JAM IRL URY LBN BWA SVK HRV TTO SVNBHR CYP AUTQAT OMN ISLCHE CAN ECU KAZ LBY UKR MAR FIN CZE SLV DZA KWT PAK CRI DNK CIV UZB PRT ROM DOM MYSHUN VNM SGP GRC HKG AGO PER ARE NLD SWE COL NGA POL ISRFRA LKAPHL EGY CHL BGD NOR VEN ESP MEXARG IRN RUS SAUKORNZL THA TUR TWN ITA IND DEU IDN GBR USA CHN ZAF BRA AUS JPN KEN −4 −2 0 Log( GDP per worker (US=1) ) Figure 7: The prospective gains from lowering trade cost by 10% versus GDP per worker. In the UNIFIED MODEL the prospective gains increase strongly as GDP per worker decreases. This patterns is substantially weaker in the PURE GRAVITY MODEL. 30 30 ZAF 20 CHN MEX IDN IND 10 RUS TUR IRN THA KOR POL SAU EGY PHL NGA BGD VEN LKA COL FRA AGO PER PRT HUN GRCGBR CZE ROM VNM MYS UZB PAK DOM DZA CIV CAN UKR MAR CRI SLV KAZ KEN TZA HRV BGR LBY NLDISL ECUTWN SYR SVK BLR JAM SDN ZWE LUX CMR LBN ETH LTU TTO YEM DNK TUN OMN AUT YUG UGA LVASVN PRY BWA BEL JOR QAT BOL URY SWE FIN IRL CHE BHR CYP ITAESP DEU 0 The prospective gains from trade (unified/gravity) BRA 0 5 CHL NZL ARG 10 Remoteness The prospective gains in the unified model Figure 8: The prospective gains fin the gravity model × remoteness. The prospective gains correspond to welfare improvements from lowering trade costs by 10%. The PURE GRAVITY MODEL systematically understates the prospective gains for remote countries. The y-axis corresponds to the prospective gains from the UNIFIED MODEL relative to the PURE GRAVITY MODEL. The x-axis corresponds to remoteness, which is calculated as weighted distance (in thousands of kilometers) from trading partners. 31
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