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Trade in Ideal Varieties: Theory and Evidence

52 Pages Posted: 2 Mar 2006  

David L. Hummels

Purdue University - Department of Economics; National Bureau of Economic Research (NBER)

Volodymyr Lugovskyy

University of Memphis - Fogelman College of Business and Economics

Date Written: December 2005

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.

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Suggested Citation

Hummels, David L. and Lugovskyy, Volodymyr, Trade in Ideal Varieties: Theory and Evidence (December 2005). NBER Working Paper Series, Vol. w11828, pp. -, 2005. Available at SSRN: https://ssrn.com/abstract=875704

David L. Hummels (Contact Author)

Purdue University - Department of Economics ( email )

West Lafayette, IN 47907-1310
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Volodymyr Lugovskyy

University of Memphis - Fogelman College of Business and Economics ( email )

Memphis, TN 38152
United States

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