Chaney (2008, AER) - Distorted Gravity: The Intensive and Extensive Margins of International Trade

Summary

  • Extention to Krugman (1980): Chaney (2008) introduces firm heterogeneity and firm-level extensive margin. Krugman assumes that firms are homogeneous and there is no selection of which firms export and which do not because firms are identically productive. Therefore, all firms export the same amount to all countries. In Chaney (2008), as trade barrier decrease, more firms with lower productivity are able to cover the fixed costs of exporting and enter the foreign market, which increases the extensive margin in terms of firm exporting.

  • Extention to Melitz (2003): Chaney (2008) includes both extensive margin and intensive margin in their model. This paper does not explicitly distinguish the cost of export and cost of production. This setting does not explain the existance of survival firms that only serve for domestic market, but allows to come up with an analytical solution to trade flows and the threshold of productivity that firms can do foreign trade.

  • In Chaney (2008), the consumer’s utility is assumed to be a Cobb-Douglas over consumption of different sectors. With in each sector, consumer has a CES utility across the differentiated varieties of goods, where $\sigma_h$ represents the elasticity of substitution between varieties in the same sector and high $\sigma_h$ represents varieties are highly substitutable within sector. The merit of the utility is that the substitution between varieties does not affect how much consumers spend on other sectors. This simplifies the analytics and leads to an elegent conclusion.

  • The productivity shock is assumed to be drew from a Pareto distribution. This ‘fat tail’ distribution is one of these that fit real data, some larger firms takes most shares of the market, and it also helps to simplify the derivation of the thresholds. Pareto distribution also ensures that the extensive margin is the diminant channel of the adjustment.

  • This paper shows that firm heterogeneity and the extensive margin plays an important role on the impacts of trade costs. Trade barriers have little impact on intensive margin of trade when varieties are highly differentiated. However, when there is less trade barrier, more firms with relatively low productivities comes into foreign market, but they are still able to capture relative large shares. Therefore, the trade flows are strongly affected by trade barriers when the market is highly differentiated ($\sigma$ is low). This conclusion contrfasts with traditional models that assumes identical firms.

Critiques

  • The conclusion of Chaney (2008) highly depend on the assumption of Pareto distribution of productivity. Those conclusions may vary if we shift to alternative distributions of firm productivity.

  • Chaney (2008) assumes an exogeneous fixed cost of exporting, which is constant across firms and countries. In reality, fixed cost could be endogeneous decided, and also could be different across firms and sectors.

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