Demand Risk and Diversification through Trade

Esposito, Federico (2019): Demand Risk and Diversification through Trade.

Abstract

I develop a theory of risk diversification through geography, where risk-averse entrepreneurs exploit the spatial correlation of demand across countries to lower the variance of sales. Both the probability of entry and trade flows to a market are increasing in the “Diversification Index”, which depends on the multilateral covariance of a country's demand with all other markets. The firms’ risk diversification behavior may imply higher welfare gains from trade than in standard trade models. Risk-augmented gravity regressions show that demand risk significantly affects trade patterns. The risk diversification channel increases welfare gains from trade by 16% relative to models with risk neutrality. The quantitative application highlights the role of demand uncertainty in shaping the economic consequences of the recent Chinese boom.

• Item Type: MPRA Paper
• Language: English
• Keywords: Demand risk; gravity; risk diversification; welfare gains from trade; China shock
• Subjects: F - International Economics > F1 - Trade; F - International Economics > F1 - Trade > F10 - General; F - International Economics > F1 - Trade > F12 - Models of Trade with Imperfect Competition and Scale Economies ; Fragmentation; F - International Economics > F6 - Economic Impacts of Globalization; F - International Economics > F6 - Economic Impacts of Globalization > F60 - General

References

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