Working Paper: NBER ID: w11828
Authors: David Hummels; Volodymyr Lugovskyy
Abstract: Models with constant-elasticity of substitution (CES) preferences are commonly employed in the international trade literature because they provide a tractable way to handle product differentiation in general equilibrium. However this tractability comes at the cost of generating a set of counter-factual predictions regarding cross-country variation in export and import variety, output per variety, and prices. We examine whether a generalized version of Lancaster's 'ideal variety' model can better match facts. In this model, entry causes crowding in variety space, so that the marginal utility of new varieties falls as market size grows. Crowding is partially offset by income effects, as richer consumers will pay more for varieties closer matched to their ideal types. We show theoretically and confirm empirically that declining marginal utility of new varieties results in: a higher own-price elasticity of demand (and lower prices) in large countries and a lower own-price elasticity of demand (and higher prices) in rich countries. Model predictions about cross-country differences in the number and size of establishments are also empirically confirmed.
Keywords: international trade; product differentiation; ideal variety model; demand elasticity; market size
JEL Codes: F1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Larger market size (D49) | Higher own-price elasticity of demand (D12) |
| Larger market size (D49) | Lower prices (D49) |
| Higher own-price elasticity of demand (D12) | Lower prices (D49) |
| Market size (L25) | Pricing of goods (D49) |
| Income levels (D31) | Prices (D49) |
| Average firm size (L25) | GDP (E20) |
| Average firm size (L25) | GDP per worker (O49) |
| Price changes (P22) | GDP growth (O49) |
| Price changes (P22) | GDP per capita growth (O49) |
| Own-price elasticity of demand (D12) | Importer GDP (F10) |
| Own-price elasticity of demand (D12) | Importer GDP per capita (F40) |