Foreign and Domestic Trade Costs, Product Variety, and the Standard of Living Across Countries

By: Alberto Cavallo, Robert C. Feenstra and Robert Inklaar

Format:Print
| Language:English

Abstract

We extend the analysis of Arkolakis, Costinot and Rodríguez-Clare (AER, 2012) to allow for differences in domestic trade costs in addition to foreign trade costs. The domestic trade costs are measured by local transportation charges and wholesaling and retailing margins. By allowing for differences in domestic trade costs, as well as in country size, productivity and in fixed costs, we are able to model both the welfare change between two equilibria and the welfare difference between two countries. We find that the extended ACR formula depends on: (a) the share of expenditure on domestic goods (reflecting in part foreign trade costs); (b) domestic trade costs; (c) the extent of product variety available to consumers. We measure the extent to which differences in the cost of living between countries are explained by these terms. We find that domestic trade costs are of comparable importance to foreign trade costs and that differences in product variety are notably more important than both of these.