Production Network Formation, Trade, and Welfare

We study the aggregate implications of production network formation in a quantitative multi-location general equilibrium trade model. Firms search for suppliers and buyers across locations subject to matching frictions, generating a gravity structure of production networks. We develop sufficient statistics for global and regional welfare and characterize the deviations from the fixed network environment, including the role of inefficiency and amplification effects of search and matching. We calibrate our multi-sector model to Chilean domestic and international firm-to-firm trade data and show that our model can rationalize the observed increase in domestic supplier linkages after Chile’s recent trade agreements. Abstracting from endogenous networks reduces Chile’s aggregate welfare losses by 20 percent when import costs are raised to their pre-agreement levels, consistent with inefficiently low equilibrium levels of search. Fixing the trade elasticity, the welfare gains from trade relative to municipality autarky drop by 40 percent due to amplification effects of search.