Author:

Keywords:

Social Sciences, Economics, Business & Economics, GEOGRAPHY, MARGINS, GRAVITY, FIRMS, 1401 Economic Theory, 1402 Applied Economics, 3502 Banking, finance and investment, 3801 Applied economics

Abstract:

This paper analyzes the impact of market size and trade costs on bilateral trade flows. A multi-country trade model with firm-level heterogeneity in productivities and countries’ market potential provides a simple micro foundation for the link between these variables. In the model, market size and trade costs jointly determine a country-specific pecking order of exporters serving their destination countries. In a counterfactual setting where bilateral trade costs are homogeneous across country pairs, market size predicts a common ranking of exporters among destination countries. This leads to a unique core-periphery structure of the world trade network. With heterogeneous trade costs, we illustrate the impact of market size and trade costs on bilateral trade flows and its margins in a simple gravity-like setting. Using an instrumental variables approach, we find that both market size and trade costs (measured through the network position of countries) have a significant impact on bilateral exports: countries in the core bilaterally trade more with other countries in the core than with peripheral countries, conditional on typical observables.