Globalization and the Gains from Variety

Since the seminal work of Krugman (1979), product variety has played a central role in models of trade and growth. In spite of the general use of love-of-variety models, there has been no systematic study of how the import of new varieties has contributed to national welfare gains in the United States. In this paper we show that the unmeasured growth in product variety from US imports has been an important source of gains from trade over the last three decades (1972-2001). Using extremely disaggregated data, we show that the number of imported product varieties has increased by a factor of four. We also estimate the elasticities of substitution for each available category at the same level of aggregation, and describe their behavior across time and SITC-5 industries. Using these estimates we develop an exact price index and find that the upward bias in the conventional import price index is approximately 1.2 percent per year. The magnitude of this bias suggests that the welfare gains from variety growth in imports alone are 2.8 percent of GDP. *We would to thank Alan Deardorff, Robert Feenstra, Jonathan Eaton, Amartya Lahiri, Mary Amiti, and Kei-Mu Yi for excellent comments and suggestions. Rachel Polimeni provided us with outstanding research assistance. David Weinstein was at the Federal Reserve Bank of New York when most of this research was done. In addition, he would like to thank the Center for Japanese Economy and Business for research support. Globalization and the Gains from Variety I) Introduction It is striking that in the quarter-century since Krugman (1979) revolutionized international trade theory by modeling how countries could gain from trade through the import of new varieties, no one has structurally estimated the impact of increased variety on aggregate welfare. As a result, our understanding of the importance of new trade theory for national welfare rests on conjecture, calibration, and case studies. This paper represents the first attempt to provide an answer to the question of how much increases in traded varieties matter for the US. Analyzing the most disaggregated US import data available for the period between 1972 and 2001, we find that consumers have low elasticities of substitution across similar goods produced in different countries. This establishes the reasonableness of a key assumption underlying the Dixit-Stiglitz (1977) framework – namely, that consumers value variety. Moreover, we find that the four-fold increase in available global varieties arising in the last 30 years has produced a large welfare gain for the United States. Increases in imported varieties have raised US real income by about 3 percent. In short, our results provide stunning confirmation of the importance of thinking about international trade within the Dixit-Stiglitz framework. In order to generate these point estimates, our work makes contributions to a number of literatures. The first is toward the measurement of prices. One of the major problems confronting economists is how to build an aggregate price index that allows for the creation of new goods and varieties. While there is general agreement that this is important, efforts to accomplish it