Revisiting the Revisited: An Alternative Test of the Monopolistic Competition Model of International Trade

This paper proposes an alternative test of the monopolistic competition model of international trade that has an implication for the relationship between the volume of trade and similarity among trading countries in the size of the economy. In the existing literature the model’s implication has been tested for aggregate trade, which includes the sectors that are not characterized by product differentiation. In contrast, this paper focuses on trade of differentiated products that the monopolistic competition model directly aims to describe, and derives an equation predicting that the volume of trade in the differentiated sectors will be larger as the trading countries are more similar in GDP and more symmetric in production structure. This prediction is tested using disaggregated data on trade and manufacturing production, employing a non-linear estimation method to handle zero-trade observations. The result shows that the predicted positive correlation between the volume of trade and the size similarity among countries is significant for both aggregate and differentiated sectors, regardless of whether the trade is among OECD or non-OECD countries. This result, contrary to Debaere’s (2005) conclusion, brings us back to the puzzle presented by Hummels and Levinsohn (1995). Moreover, the proposed alternative approach in this paper demonstrates the following: (i) trade in the differentiated sectors among OECD countries is very well explained by the monopolistic competition model; however, (ii) for non-OECD countries, the predicted relationship between the volume of trade and the (adjusted) size similarity among countries is more pronounced in the non-differentiated sectors than in the differentiated sectors, which is counter to what the model suggests. The second point suggests that trade flows among non-rich countries may be driven or crucially influenced by some other mechanism than what is described by the monopolistic competition model.