Why countries trade Insights from firm-level data

Two theories dominate economic thinking on the causes of international exchange. Comparative advantage explains trade by inherent differences between countries. Increasing returns explains trade by the productivity and variety advantages from specialization and exchange even among like economies. But one-hundred-eighty years after the publication of Ricardo’s “Principles,” and two decades into the “new trade theory” revolution, we know little about their relative importance in giving rise to observed trade patterns.1 An assessment of their relative importance would require identifying features which distinguish the theories, and employing appropriate data to quantify the relative contributions. While the theories are quite distinct at the microeconomic level, it has proven very difficult to identify features of aggregate trade patterns which would help to distinguish the theories. In particular, two features of trade patterns which have in the past been advanced as distinguishing the theories—intra-industry and North–North trade—do not help to separate the theories (Chipman (1988), Davis (1995, 1997), Harrigan (1994)). Since the available data has most frequently concerned trade flows at a reasonably aggregated level, it was inherently difficult to formulate a test of the theories. Davis and Weinstein (1996, 1999, 2003), do place comparative advantage and increasing returns in direct contest, and quantifies their relative importance in contributing to production structure within the OECD, and across regions of Japan. Similar efforts have been made by Head and Ries (2001) and Trionfetti (2001). Two qualifications should be noted. First, that work provided an appropriate test of the two theories, but they quantified the contribution