Trade in Ideal Varieties: Theory and Evidence

David Hummels and Volodymyr Lugovskyy

No 11828, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Models with constant-elasticity of substitution (CES) preferences are commonly employed in the international trade literature because they provide a tractable way to handle product differentiation in general equilibrium. However this tractability comes at the cost of generating a set of counter-factual predictions regarding cross-country variation in export and import variety, output per variety, and prices. We examine whether a generalized version of Lancaster's 'ideal variety' model can better match facts. In this model, entry causes crowding in variety space, so that the marginal utility of new varieties falls as market size grows. Crowding is partially offset by income effects, as richer consumers will pay more for varieties closer matched to their ideal types. We show theoretically and confirm empirically that declining marginal utility of new varieties results in: a higher own-price elasticity of demand (and lower prices) in large countries and a lower own-price elasticity of demand (and higher prices) in rich countries. Model predictions about cross-country differences in the number and size of establishments are also empirically confirmed.

JEL-codes: F1 (search for similar items in EconPapers)
Date: 2005-12
New Economics Papers: this item is included in nep-int and nep-upt
Note: ITI
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

Published as Hummels, David, and Volodymyr Lugovskyy. "International Pricing in a Generalized Model of Ideal Variety." Journal of Money, Credit, and Banking 41 (February 2009): 3-33.

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