Non-homotheticity and Bilateral Trade: Evidence and a Quantitative Explanation

Standard empirical models of international trade (i.e., gravity type models) predict that trade flows increase with both importer and exporter total income, but ignore how total income is divided into income per capita and population. Bilateral trade data, however, show that trade

grows strongly with income per capita but is largely unresponsive to population. I develop a general equilibrium, Ricardian model of international trade that allows for the

elasticities of trade with respect to these two variables to diverge. Goods in the model are subdivided into types, which may differ in two respects: income elasticity of demand and the extend of heterogeneity in production technologies. In equilibrium, low income countries consume relatively more goods of the low income elasticity types, and they have a comparative advantage in producing goods with low levels of heterogeneity in production technologies. Conversely,

high income countries consume relatively more income-elastic goods and have a comparative advantage in producing goods with high levels of heterogeneity in production technologies. I calibrate the model, with two types of goods, to data on the bilateral trade flows of 144 countries and compare its quantitative implications to those of a special case in which the model delivers the gravity equation (i.e., with no distinction between income per capita and population). The general model improves the restricted model’s predictions regarding variations in trade due to a country’s size and income per capita. For example, the effect from doubling a country’s income per capita on the share of trade in that country’s GDP is a 2.1% increase

according to the data, a 2.1% increase according to the general model, and a 5.7% decrease according to the restricted model. I use the model to analyze counterfactuals. A technology shock in China increases the welfare of rich countries, decreases that of middle income countries, and leaves poor countries indifferent. A shock that quadruples China’s income increases wages in the 50 richest countries by 0.5% relative to the rest of the world. In contrast, the restricted model implies that a technology

shock in one country increases the welfare of all countries, and preserves their relative wages (except with respect to the country experiencing the shock).

For more information, contact Wilfred Ethier.