Robust Counterfactual Predictions in Neoclassical Models of International Trade

Project Outcomes Statement

In order to evaluate or predict the impact of various aspects of globalization, economists and policymakers commonly rely on quantitative models. These models are constrained so as to replicate features of the observed past, but how exactly a researcher imposes those constraints is notoriously difficult (and hence inevitably uncertain and subject to debate). This project has aimed to make this connection between model and observed historical data as simple and robust as possible.

Our first contribution is a methodology to construct nonparametric counterfactual predictions, free of functional form restrictions on preferences and technology, in neoclassical models of international trade. This begins by establishing the equivalence between such models and reduced exchange models in which countries directly exchange factor services. This equivalence implies that, for an arbitrary change in trade costs, counterfactual changes in the factor content of trade, factor prices, and welfare only depend on the shape of a reduced factor demand system. It goes on to provide sufficient conditions under which estimates of this system can be recovered nonparametrically. Together, these results offer a strict generalization of the parametric approach used in so-called gravity models. As an application we re-evaluate the aggregate welfare consequences of China's recent integration into the world economy.

Our second contribution moves from aggregate outcomes to examine impacts of international trade on earnings inequality across individuals within any given country. We begin with the observation that individuals’ earnings depend on the demand for the factor services they supply. Accordingly, international trade can affect earnings inequality because either: (i) foreign consumers and firms demand domestic factor services in different proportions than domestic consumers and firms do, an export channel; or (ii) domestic consumers and firms change their demand for domestic factor services in response to the availability of foreign goods, an import channel. Building on this idea, we develop new measures of export and import exposure at the individual level and provide estimates of their incidence across the earnings distribution. The key input fed into our empirical analysis is a unique administrative data set from Ecuador that merges firm-to-firm transaction data, employer-employee matched data, owner-firm matched data, and firm-level customs transaction records. We find that export exposure is pro-middle class, import exposure is pro-rich, and in terms of overall incidence, the import channel is the dominant force. As a result, earnings inequality in Ecuador is higher than it would be in the absence of trade.