Firm Heterogeneity and the Mystery of Diverging Trade: a demand-based explanation

Over the last decade, "Per-Capita Income" has made its comeback to Trade literature through a handful of papers. Fieler (2011)’s seminal work has clarified the "Linder Hypothesis" (1961) which has been misinterpreted for a long time by showing that similarity in demand structure is only driven by identical per-capita income levels. Saure (2012) stresses that the number of imported varieties grows strongly with Income per-capita. Markusen (2013) "puts Per-Capita Income back to Trade Theory" and associates it with Non-Homothetic preferences to a provide a demand-side rationale for pricing to markets, the mystery of missing Trade and other facts.

More recently, Simonovska (2015) has revealed a remarkable empirical regularity: Aggregate prices of tradable goods are high in rich countries and low in poor countries. Another major conjecture has been observed by Disdier et al. (2015). The authors find that "North-South Standards Harmonization" fosters North-South trade at the expense of South-South trade and predict that excluded Southern countries might suffer.

My intuition is that these two major empirical facts outlined above have a common theoretical explanation, where per-capita income plays a central role. I need then to propose a monopolistic competition model with asymmetric countries and non-CES preferences in order to go beyond its restrictions. It has been well documented that due to its simplicity and tractability, the CES model of monopolistic competition, pioneered by Dixit-Stiglitz (1977), has become the workhorse of New Trade Theories. Yet it is fair to stress that this model is very restrictive and provides a rigid demand system. In fact, under CES preferences, the major demand indicators such as: the price elasticity of demand, the elasticity of substitution between varieties, the Relative Love for Variety(RLV) are not only, constant, but also, exogenous.

Therefore, I build on Bertoletti&Etro (2013) and extend their model of monopolistic competition with indirectly additive preferences in two directions: I allow, not only, prices to vary across firms within any country, but also, per-capita income to vary across countries. Contrary to CES models, I find that the elasticity of substitution between varieties is firm specific and decreasing in per-capita income. This
result has two appealing implications for firm heterogeneity and country-level asymmetry.

First, it provides a new demand-based rationale for firm heterogeneity. That is, in any country, more productive firms are more profitable since they, not only, earn higher revenues, but also, enjoy higher markup rates as long as their varieties are cheaper (see graph below), provide the consumer with a higher initial level of sub-utility and thus are harder to substitute. Second, using per-capita income as the unique source of asymmetry high-income(North) and low-income(South) countries, the model shows that rich markets are more profitable since firms produce more and charge higher markups to the rich representative consumer as long as he cares more about product diversity and less about prices.
This higher(lower) profitability of the Northern(Southern) market makes it easier(harder) to penetrate for foreign exporters. This implies that exporters serving the Northern(Southern) destination are on average less(more) productive and charge on average a higher(lower) marginal cost to Northern(Southern) consumers.
Hence, we observe high(low) prices of tradable goods in Rich(Poor) countries, not only, because foreign exporters charge higher(lower) markups to Northern(Southern) consumers as long as they are less(more) price sensitive (as shown by Bertoletti&Etro (2013) and Simonovska (2015)), but also, due to easier(tougher) selection into exporting to Northern(Southern) markets.

Moreover, since Northern markets are more attractive for Southern exporters, they tend to export more to the North and less to symmetric Southern destinations after "North-South Standards Harmonization". Finally, this "Trade Divergence" generates a welfare gain for the North and its Southern partner while the excluded Southern country experiences a welfare loss.

References

Bertoletti, P. and Etro, F. (2013): "Monopolistic Competition When Income Matters," (Technical report no 55. Department of Economics and Management, University of Pavia).

Disdier, A. C. , Fontagne, L. and Cadot, O. (2015): "North-South Standards Harmonization and International Trade," World Bank Econ Rev (2015) 29 (2): 327-352.

Dixit, A. and Stiglitz, J. (1977): "Monopolistic Competition and Optimum Product Diversity," The American Economic Review, 67, 297-308

Fieler, A. C. (2011): "Non-homotheticity and Bilateral Trade: Evidence and Quantitative Explanation," Econometrica, 79, 1069-1001

Linder, S. B. (1961): "An Essay on Trade and Transformation," Almqvist and Wiksell,Stockholm

Markusen, J. R. (2013): "Putting per-capita income back into trade theory," Journal of International Economics, 90, 255-265

Saure, P. (2012): "Bounded Love of Variety and Patterns of Trade," Open Economies Review, 23, 645-674

Simonovska, I. (2015): "Income Di_erences and Prices Of Tradables: Insights from an Online Retailr ," Review of Economic Studies, 1-45