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Can multi-stage production explain the home bias in trade?

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Kei-Mu Yi

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Abstract

A large empirical literature finds that there is too little international trade, and too much intra-national trade to be rationalized by observed international trade costs such as tariffs and transport costs. The literature uses frameworks in which goods are assumed to be produced in just one stage. This paper investigates whether the multi-stage nature of production helps explain the home bias in trade. The author shows that multi-stage production magnifies the effects of trade costs. He then calibrates a multi-stage production model to the U.S. and Canada. He solves the model with measures of trade costs constructed from data on tariffs, transport costs, and wholesale distribution margins. The model can explain about 3/8 of the Canada border effect; this is three times more than what a calibrated one-stage model can explain. The model also explains a good deal of Canada’s vertical specialization trade. Finally, a reverse engineering exercise suggests that the unknown or unobserved component of trade costs is smaller than observed trade costs.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 08-12.

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Date of creation: 2008
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Handle: RePEc:fip:fedpwp:08-12

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Keywords: Production (Economic theory) ; Trade;

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  8. Hillberry, Russell & Hummels, David, 2008. "Trade responses to geographic frictions: A decomposition using micro-data," European Economic Review, Elsevier, vol. 52(3), pages 527-550, April. [Downloadable!] (restricted)
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  18. Combes, Pierre-Philippe & Lafourcade, Miren & Mayer, Thierry, 2005. "The trade-creating effects of business and social networks: evidence from France," Journal of International Economics, Elsevier, vol. 66(1), pages 1-29, May. [Downloadable!] (restricted)
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  22. Keith Head & Thierry Mayer, 2002. "Illusory Border Effects: Distance Mismeasurement Inflates Estimates of Home Bias in Trade," Working Papers 2002-01, CEPII research center. [Downloadable!]
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  24. Russell H. Hillberry, 2002. "Aggregation bias, compositional change, and the border effect," Canadian Journal of Economics, Canadian Economics Association, vol. 35(3), pages 517-530, August. [Downloadable!] (restricted)
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  31. Kei-Mu Yi, 2003. "Can Vertical Specialization Explain the Growth of World Trade?," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 52-102, February. [Downloadable!] (restricted)
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  32. Keith Head & John Ries, 2001. "Increasing Returns versus National Product Differentiation as an Explanation for the Pattern of U.S.-Canada Trade," American Economic Review, American Economic Association, vol. 91(4), pages 858-876, September. [Downloadable!] (restricted)
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    Other versions:
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