When Are Variety Gains from Trade Important? Domestic Productivity and the Cost of Protectionism

In an influential paper, Romer (1994) shows that the welfare gains from trade are substantially increased when trade liberalization expands the set of differentiated products available in an economy. However, in his model and subsequent research, the variety gains are magnified by the assumption of no or very limited competition between imported and domestic differentiated products. We extend the existing literature by endogenizing the domestic supply of differentiated products. In our model, those countries with a stronger comparative advantage in producing differentiated products will import fewer foreign goods and enjoy lower variety gains from trade. Moreover, higher trade barriers will hurt them less because these countries are more efficient in substituting for the disappearing foreign varieties with domestic varieties. Next we take the model to the data, measuring the strength of a country’s comparative advantage by its export performance. For an average good, doubling the importer’s export performance relative to exporter’s results in a 20 percent decrease in the number of imported varieties for a median trade barrier. The effect varies across sectors with ‘machinery and transportation’ and ‘electronics’ featuring the strongest effect. A direct welfare implication is that laggard countries or sectors stand to lose more from higher trade barriers.