Inequality, nonhomothetic preferences, and trade: a gravity approach.

• Author: Dalgin, Muhammed
• Position: Theory of international trade studies income distribution pattern - Author abstract

1. Introduction

   One basic tenet of the standard theory of international trade is that tastes are homothetic. For a long time this was a convenient simplification because, along with the assumption that tastes are also identical across countries, it allowed trade theorists to concentrate on the supply side as an explanation for the causes of international trade. However, what started out as a convenient modeling technique propagated into virtually all empirical work in international trade, regardless of whether the assumption on homotheticity is empirically tenable or not. This is problematic because, as we review in more detail below, there is consistent and robust evidence that tastes cannot properly be considered to be homothetic. In particular, one conclusion from accepting the nonhomotheticity of tastes is that income distribution and income per capita become arguments for the aggregate demand function. Because one country's international trade is given by its aggregate supply minus its aggregate demand, we conclude that income distribution and income per capita are important determinants of international trade from the demand side. (1) This effect has been almost completely absent from the empirical trade literature. (2) In particular, as we argue further on, the standard gravity model, which has been used widely to explain trade flows among countries, can only be considered to be complete if it does include income distribution and income per capita as explanatory variables.

   Specifically, we propose in this paper to demonstrate the role that income distribution plays in international trade, while also controlling for income per capita. To enhance the persuasiveness of our results, it is crucial that we rely on the most standard and successful empirical model of trade, the gravity model previously mentioned. Thus, we are quite purposeful in excluding the possibility that our results stem in any way from an innovation in the methodology. The gravity model, which explains the volume of trade by the economic masses of the trading partners and the distance between them, has been remarkably successful. In practical applications, researchers sometimes call its use the "modified gravity methodology" because, depending on the question that the researcher intends to ask, she modifies the basic model with some variable or variables of interest. For example, in the first paper (to our knowledge) to look at the impact of the Internet on trade, Freund and Weinhold (2004) include variables on the number of Web hosts in each country to show that they have a positive impact on trade. Dunlevy (2006) asks the question: What is the impact of the immigrant population in the United States on state-level trade with foreign nations? Naturally, he uses the stock of immigrants in each state as his main explanatory variable. Hutchinson (2005) wants to study the impact of language differences on trade, taking the interesting stance that what matters most is how much languages differ from one another. Therefore, he modifies the gravity model with a measure of linguistic distance (Japanese being more distant from English than Dutch from English, for example). As a final recent example of this methodology, Rose (2004) augments the gravity model with membership in the World Trade Organization/General Agreement on Tariffs and Trade (WTO/ GATT) to ask whether the WTO enhances trade. Surprisingly, he is unable to find any significant effect of membership in the WTO/GATT on trade.

   We begin our argument with the empirical fact that tastes cannot be considered to be homothetic. The evidence that all goods do not have unit income elasticity of demand abounds in the literature. In particular, the papers by Hunter and Markusen (1988) and Hunter (1991) specifically test for nonhomotheticity of preferences by estimating linear income-expansion paths that have intercepts significantly different from zero. Their model is consistent with a minimum subsistence level for one good (N), causing consumers at very low levels of income to consume good N only, purchasing the other good (L) only at higher levels of income. Good N is a necessity and good L is a luxury, in the sense that their income elasticities of demand are below and above 1, respectively. The strongest prediction of Hunter and Markusen's and Hunter's models is that income per capita is a determinant of aggregate demand. If income per capita increases in a perfectly equal country with a representative consumer, she increases her budget share of the luxury good in response. Note that while the positive intercepts of the income-expansion paths make budget shares a function of per capita income, the linearity of the paths imply that income redistribution, holding per capita income constant, has no impact on the demand for each good, as long as everyone's income is sufficiently high to consume both goods.

   Further empirical evidence is provided by Thursby and Thursby (1987). They estimate a gravity model augmented with income per capita, finding that countries with more similar incomes per capita trade more. They ascribe this result to countries with similar GDP per capita having similar consumption patterns, which is an indication of nonhomothetic tastes, and stems directly from the Linder (1961) theory that they are trying to test. Note that this paper is closer to our framework than the aforementioned pieces by Hunter and Hunter, and Markusen, because, like us, Thursby and Thursby also estimate a gravity model. However, their paper differs from our approach in that they also do not allow for a role for income distribution.

   The empirical work mentioned in the preceding paragraphs shows that income per capita plays an important role in the determination of expenditure shares, thereby establishing the importance of nonhomotheticity in tastes. But only Francois and Kaplan (1996) look at the effect of income distribution, and in particular of inequality, on trade. However, note that they perform this in a nongravity setting. More specifically, they look at inequality in developing countries as a determinant of the shares of imports of manufactured goods from developed countries. They find that these shares increase with the inequality of the developing country (and with its per capita income), and more so in product categories that are more differentiated, according to their classification of product differentiation.

   Having established from previous work that tastes should properly be considered to be nonhomothetic, we consider in the next section the possibility that they are so in a way that makes income-expansion paths have some curvature. As has already been pointed out, this is different from the work of Hunter (1991) and Hunter and Markusen (1988). See also the seminal contribution of Markusen (1986), who also considers income-expansion paths that are linear but with an intercept. When the income-expansion path is actually curved, income distribution becomes a determinant of aggregate demand and therefore of trade flows. The intuition is simple. Imagine that income is redistributed in a country, by taking one dollar from the poor and giving it to the rich. Given curved income-expansion paths, the same dollar will be used by the rich to buy proportionately more luxuries than before. Then, aggregate demand for luxuries increases, and aggregate demand for necessities decreases. All else being equal (including the country's total income, its income per capita, and the income of all other countries), this country will import more luxuries. Therefore, a country pair's GDPs and the distance between them, which constitute the backbone of the gravity model, cannot be considered to be a complete model to determine world trade flows. At a minimum the gravity model must be augmented with income per capita and a measure of income distribution.

   We use these insights to set up our own modified gravity model. We then ask whether these measures perform according the theoretical predictions. But to do that we need to identify which goods are necessities and which goods are luxuries. In our main approach, we use consumer data from the Bureau of Labor Statistics (BLS), along with a concordance that we created between BLS product categories and Standard International Trade Classification (SITC) codes, to categorize goods into luxuries and necessities at the four-digit SITC level. We then use our classification to reaggregate trade flows into luxuries and necessities, and estimate the gravity model separately for imports of either type of good.

   A summary of our results follows. From the cross-country regressions for the 1990s, (3) we find strong support for imports of luxuries being positively related to importing country inequality, and imports of necessities being negatively related to it, exactly as our theory predicts. We also find (qualified) support from our panel estimation spanning the last three decades. Here the composition of trade also switches toward luxuries and away from necessities as inequality goes up, as we would have predicted. However, for full sample estimations, despite the presence of this relationship between trade composition and inequality, trade volume in both kinds of goods seems to increase with inequality. This is perhaps not as surprising as it might at first seem. Note that our necessity-luxury classification is based on U.S. household data for 2001. Even with identical tastes (an assumption that we maintain throughout), many goods are likely to be luxuries for low income consumers and necessities for consumers at higher incomes. Therefore we conjectured that the necessity-luxury classification is more valid for more developed countries, whose populations are at approximately the same income levels as that of United States. One way to check this was to restrict our panel to include only country pairs in which the importing country is developed, while keeping the...