Distorted Trade Barriers: A Dissection of Trade Costs in a "Distorted Gravity" Model

It is quite common in the trade literature to use iceberg transport costs to represent variable trade barriers, both tariffs and shipping costs alike. However, in models with monopolistic competition these are, in fact, not identical trade restrictions. This difference is not driven by tariff revenue but by how the two trade costs affect firm profits and the extensive margin. We illustrate these differences in a gravity model `a la Chaney (2008). We show theoretically that trade flows are more elastic with respect to ad valorem tariffs than transport costs and find a linear relationship between the elasticities with respect to ad valorem tariffs, iceberg transport costs, and fixed market costs. We empirically validate these results using data on U.S. product-level imports.