Beyond Gravity: the Composition of Multilateral Trade Flows

I develop a novel view of comparative advantage that collectively explains (i) the effect of distance and GDP per capita on the price composition of trade, and (ii) the systematically higher trade-to-GDP ratio of rich countries. There are two types of goods, which offer different scopes for product differentiation. In equilibrium, rich and remote countries have (endogenously determined) comparative advantage in the highly-differentiated type, whereas poor countries have comparative advantage in the less-differentiated type. I combine the new channel of comparative advantage with National Product Differentiation to construct a unified model of trade. The unified model extends beyond standard gravity models as it characterizes both the volume and the product composition of foreign trade. Remarkably, in the unified model, despite homothetic preferences rich and poor countries have systematically different consumption structures, and iceberg (ad-valorem) trade costs distort the price composition of exports across space. I estimate the unified model using bilateral trade data on 100 countries and compare it to a special case, which delivers the standard gravity equation. The unified model fits the data significantly better than the standard gravity model. The estimated gains from trade are substantially larger than the standard model, and more unequally distributed across nations. Importantly, when accounting for the role of composition, further liberalization of trade systematically favors poor and remote countries.