Abstract:
The workhorse model of the New Trade Theory fails to explain four strong and central
patterns of postwar trade data. These patterns are, first, the massive increase in trade
volumes, second, the small fraction of traded varieties the average country imports,
third the correlation between per capita income growth and trade growth, and fourth, the
correlation between trade growth and growth in the number of source countries per
imported good. The present paper shows that a small and reasonable change in the
demand structure can reconcile the model with the data. It departs from standard theory
by assuming that consumers derive bounded marginal utility from varieties. This
implies that consumers purchase only the cheaper share of varieties and that expensive
foreign varieties bearing high transport costs are not imported. Technological progress
which increases per capita consumption of the varieties in the consumption basket
decreases marginal utility derived from each of them and induces consumers to extend
their consumption to more expensive varieties produced at more distant locations. This
additional margin along which trade can expand induces a substantial increase in the
trade share as productivity grows. Productivity change is thus identified as a joint
determinant of trade shares, the number of source countries per good, and per capita
income, explaining the trends and correlations in the data.
