EconPapers    
Economics at your fingertips  
 

Demand Risk and Diversification through Trade

Federico Esposito

MPRA Paper from University Library of Munich, Germany

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. Using a panel of domestic and international sales of Portuguese firms, I estimate “risk-augmented” gravity regressions, which show that the Diversification Index significantly affects trade patterns at the extensive and intensive margins. I quantify that the risk diversification channel 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.

Keywords: Demand risk; diversification; welfare gains from trade; international trade (search for similar items in EconPapers)
JEL-codes: F1 F10 F15 (search for similar items in EconPapers)
Date: 2020-05-20
New Economics Papers: this item is included in nep-int
References: Add references at CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
https://mpra.ub.uni-muenchen.de/100511/1/MPRA_paper_100511.pdf original version (application/pdf)

Related works:
Working Paper: Demand Risk and Diversification through Trade (2019) Downloads
Working Paper: Demand Risk and Diversification through Trade (2019) Downloads
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:100511

Access Statistics for this paper

More papers in MPRA Paper from University Library of Munich, Germany Ludwigstraße 33, D-80539 Munich, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Joachim Winter ().

 
Page updated 2025-03-22
Handle: RePEc:pra:mprapa:100511