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Demand Risk and Diversification through International Trade

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  • Esposito, Federico

Abstract

I develop a theory of risk diversification through geography. In a general equilibrium trade model with monopolistic competition, characterized by stochastic demand, risk-averse entrepreneurs exploit the spatial correlation of demand across countries to lower the variance of their global sales. I show that the model-consistent measure of demand risk, the “Diversification Index”, depends on the multilateral covariance of a country's demand with all other markets. The model implies that both the probability of entry and the level of trade flows to a market are increasing in the Diversification Index. The firms' risk diversification behavior can generate, upon a trade liberalization, a strong competitive pressure on prices, which in general equilibrium can lead to higher welfare gains from trade than the ones predicted by trade models with risk neutrality. To assess the quantitative relevance of the risk diversification channel, I rely on a panel of domestic and international sales of Portuguese firms. I estimate “risk-augmented” gravity regressions at the firm and country level, and show that the Diversification Index significantly affects trade patterns at the extensive and intensive margins. Once I structurally estimate the model, I document that the risk diversification channel explains 15% of the observed trade patterns, and increases welfare gains from trade by 16% relative to models with risk neutrality. Finally, the quantitative application highlights the role of demand uncertainty in shaping the economic consequences of the recent integration of China in the global economy.

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  • Esposito, Federico, 2020. "Demand Risk and Diversification through International Trade," MPRA Paper 100865, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:100865
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    Cited by:

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    2. Raphael Lafrogne-Joussier & Julien Martin & Isabelle Mejean, 2023. "Supply Shocks in Supply Chains: Evidence from the Early Lockdown in China," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 71(1), pages 170-215, March.
    3. Cristina Constantinescu & Ana Margarida Fernandes & Arti Grover & Stavros Poupakis & Santiago Reyes, 2022. "Globally Engaged Firms in the Covid-19 Crisis," CESifo Working Paper Series 9711, CESifo.
    4. Esposito, Federico & Hassan, Fadi, 2023. "Import competition, trade credit and financial frictions in general equilibrium," LSE Research Online Documents on Economics 121378, London School of Economics and Political Science, LSE Library.
    5. Sarah Guillou & Karsten Mau & Tania Treibich, 2023. "Firms’ financial vulnerabilities during COVID-19: Was the French support package too generous ?," Working Papers hal-03981175, HAL.
    6. Raymond Fisman & April Knill & Sergey Mityakov & Margarita Portnykh, 2022. "Political Beta [The impact of the 2018 tariffs on prices and welfare]," Review of Finance, European Finance Association, vol. 26(5), pages 1179-1215.
    7. Hassan, Fadi & Esposito, Federico, 2023. "Import Competition, Trade Credit, and Financial Frictions in General Equilibrium," CEPR Discussion Papers 17926, C.E.P.R. Discussion Papers.
    8. José Fillat & Stefania Garetto, 2021. "On the Origins of the Multinational Premium," Working Papers 21-20, Federal Reserve Bank of Boston.
    9. Tasso Adamopoulos & Fernando Leibovici, 2024. "Trade Risk and Food Security," Working Papers 2024-004, Federal Reserve Bank of St. Louis, revised Feb 2024.

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    More about this item

    Keywords

    Demand uncertainty; welfare gains from trade; diversification; China shock;
    All these keywords.

    JEL classification:

    • F10 - International Economics - - Trade - - - General
    • F12 - International Economics - - Trade - - - Models of Trade with Imperfect Competition and Scale Economies; Fragmentation
    • F14 - International Economics - - Trade - - - Empirical Studies of Trade

    NEP fields

    This paper has been announced in the following NEP Reports:

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