Endogenous market price index, trade frictions and elasticity of substitution

This paper establishes a model to explore how all the countries in the world export to an importer. The trade frictions of an exporter include both a variable cost and a fixed cost, and the exporter’s bilateral trade relationship is represented by the exported value, the number of exporting firms, and the average price of exported products. The model relaxes the usual assumption that the price index in the market is exogenous (see, e.g., Chaney, 2008), and this leads to the following main results. First, the trade frictions negatively affect its own bilateral trade relationship and positively affect all its cross bilateral trade relationships. Nonetheless, the variable cost has positive effect on its own average product price. The sizes of all the effects are related to the market share of the exporter. Second, the trade frictions have impact on the total number of firms in the market and the bilateral trade relationship is influenced by the Elasticity of Substitution (ES) of the market. Both effects increase with the fixed cost. Finally, the price index is positively affected by both the trade frictions and the ES. Raising the ES can reduce the total number of exporting firms in the market. ∗University of Essex. Wivenhoe Park, Colchester CO1 1ED, United Kingdom. E-mail: [email protected]. An earlier version of this paper is part of my PhD thesis. I am grateful to Holger Breinlich and João Santos Silva for many helpful comments and guidance. The usual disclaimer applies.