ROLE OF DIFFERENTIATING GOODS: Modeling Bilateral Trade


Our theoretical results indicate that the home market effect should be larger for differentiated goods with free entry than for homogeneous goods with restricted entry. We test this hypothesis in our empirical work. We regress bilateral exports (from one country to each of its trading partners) on domestic- and partner-country GDP (and other controls). We are interested in the elasticity of exports with respect to domestic GDP, since our theory indicates that the size of this elasticity depends on the type of good.

We expect to see higher elasticities for manufacturing goods with few entry barriers, and smaller elasticities for homogeneous goods with more entry barriers (e.g., because they are resource-based). Using Rauch’s (1999) classification, we divide our sample into three; homogeneous goods, differentiated goods, and an in-between category.

We then estimate gravity equations over aggregate bilateral exports in each of these three groups. As we move from homogeneous to differentiated goods, we indeed find that the elasticity of exports with respect to own GDP rises significantly. This finding is empirically robust and significant both economically and statistically. It is also consistent with the theoretical hypothesis that the home market effect is more prevalent for differentiated goods where entry is easy, than for homogeneous goods with restricted entry. Further conclusions are given in section 5.
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Modeling Bilateral Trade in Homogeneous Goods with Reciprocal Dumping’

We consider a two-country model where each country has two industries, and labor is the only factor. The first industry uses one unit of labor to produce each unit of output. There are no transport costs for international trade in this good. Provided that it is produced in both countries, the wage is equalized across countries and is set at unity. The second industry produces a homogeneous good under Coumot-Nash competition, where markets are segmented across countries, (i.e., have different prices). Let Xjj denote the amount produced of this good in country i and sold in country j, i,j=l,2. There is free entry of firms; N\ denotes the equilibrium number of firms located in country i.

With equalized wages, the marginal cost of producing in the Coumot-Nash industry is also equalized across countries, and is denoted by c. The fixed costs of production are F. A firm located in country i and selling to country j faces “iceberg” transport costs, so that if one unit of the good is shipped, only l/ту < 1 units arrive. This means that the marginal cost of exporting is cTjj.