Quality and Gravity in International Trade

Flach, Lisandra; Unger, Florian (September 2016): Quality and Gravity in International Trade. No. 12602. CESifo Working Paper No. 6080

Abstract

This paper introduces quality innovations with endogenous sunk costs in a heterogeneous firm model of international trade and derives implications for the gravity equation. The model predicts that the effect of fixed costs on exports and on the share of exporters is lower in industries with a higher degree of vertical product differentiation. We use both aggregate trade data and firm-level data to estimate gravity equations and find strong evidence for a dampening effect of vertical differentiation on the fixed costs elasticity in international trade. Moreover, we estimate the parameters of our model and simulate the effects of a reduction in fixed trade barriers. Accounting for quality lowers the positive gains from trade and leads to more heterogeneous effects across industries compared to a trade model without quality investments. Consistent with our theory, vertical differentiation affects exports via sunk costs and the extensive margin, whereas the effect of variable trade costs does not depend on quality.

• Item Type: Paper (Discussion Paper)
• Keywords: International trade; heterogeneous firms; gravity; product quality
• Faculties: Economics > Chairs > Seminar for Economic Theory; Economics > Chairs > Seminar for International Trade Theory and Trade Policy
• Subjects: 300 Social sciences > 330 Economics
• JEL Classification: F12, F14, L11
• Language: English